I’ve done it. Now, I know better. If you have liquid savings, except under very specific circumstances, you should not carry balances on your credit cards.
Here’s what the matter is with this very common scenario: you’re losing money. Let’s say you have $15,000 in liquid savings and $2,500 in credit card debt at 8% APR:
- You are paying about $200/year in interest on your credit card.
- Your $15k savings earns about $187/year (at 1.25% interest).
- After paying off your credit card, your remaining $12,500 of savings will make $156/year.
- You pay $0 in credit card interest.
- the math: $187 (interest earned) – $200 (interest paid) = $13 PAID vs. $12,500 in savings at 1.25% interest earning $156/year.
Making $156 per year is better than paying $13 per year.
If you have liquid savings – savings you can access without selling stock, or property or taking a loan out against your 401k (a huge no-no) – you should pay off your credit cards even if it decreases your “rainy day” or even “emergency” savings. Remember, I said ‘decreases’ and not ’empties’. Do not empty your emergency savings to pay off debt. You should be saving some each year. For paying off debt, do not take more out of your emergency savings than you can save in one year.
We all put our money into separate mental categories: savings, spending, food, retirement, etc. It’s hard to think, “I’ll move my money from my savings to my credit card.” It’s easier to think “I’ll pay some extra each month and it will only take a few months to pay off my balance.” For the most part, it takes people months if not years to slowly pay down their credit card balances because of 2 reasons:
- there is always far less left at the end of the month to put against your credit card balance than you thought
- stuff comes up. You try to pay an extra $400/month on your credit card, but you didn’t notice that your daughter’s art class fees where due that month.
It’s a vicious (not to mention costly) cycle.
Try a new way of thinking. Lose the categories, or most of them, and think of your money as a pool of assets. You want that pool of assets to always be in the optimal position (always making the most return and paying/losing the least). If we follow that rule, take the $2500 from your liquid savings and pay off your credit card. Today.
I would also ask you to to cut your spending, to make sure it doesn’t happen again, but I would still advise you to pay off that balance with your liquid savings.
There are some exceptional circumstances were I would NOT advise a client to pay off their credit card.
- if you do not have at least $3000 of liquid Rainy Day (see my article on the difference between Rainy Day and Emergency savings) savings remaining after you pay off the credit card balance.
- Second, if you have no liquid savings and would need to sell stock or property because the transaction costs or market risk may outweigh the savings you get from paying off your credit card.
- if you are worried about your income in the foreseeable future (e.g. impending layoffs at your company), you would want to keep more money in liquid savings.
If you are not in any of the exceptional circumstances, you should let go of your mental money categories. Break free! Start looking at your money as a pool, looking for the best position for all your assets.