When is it worth it to dip into savings to get rid of debt? Should I use some of my $8k in savings to pay off my $11k line of credit?
I tend to divide debt into two categories. One type of debt works like a one-way street. The loan is paid off and then it’s gone. Mortgages and car loans, for instance, tend to be what I call “vanishing debt” because once you pay them off, the account you were paying off is gone. You can’t dip back into the same account to borrow more money – at least not without reapplying.
The second type of debt I refer to as “reusable debt”. Credit cards and lines of credit (LoC) fall under this category because we can borrow money from these accounts, pay it off, then withdraw more money. When I buy something with my credit card, I can pay off the bill and then buy something else with my credit card. I don’t need to apply for a new credit card each time I want to make a purchase.
When it comes to paying off debts, I usually recommend people use their savings to pay down their reusable debts as quickly as possible. My reasoning basically boils down to two points. The first is that you can pay down the debt now and, if all goes well, it’ll stay paid down. However, if something goes wrong and you need the money for something else then you can withdraw it from the line of credit again. Assuming there is no penalty to transferring money between your accounts there is no drawback to paying down your line of credit and then borrowing from it again later as needed.
The other reason I recommend using savings to pay down a reusable debt (such as a credit card or line of credit) is this: By leaving money in your savings account while still having debt on your line of credit you’re basically paying the bank to leave money in your savings account.
This idea might be understand with an example. Let’s say you’ve got $8,000 in your savings account, presumably at little to no interest. Meanwhile you’ve got $11,000 of debt on your line of credit. Your net worth in this instance is -$3,000. Let’s say, just for the sake of this example, the interest rate on your line of credit is 7%. This means you’re paying around $64 every month on your line of credit just to maintain the status quo.
Now, what happens if you transfer most of your $8,000 in savings to your line of credit? If you move $7,000 to your line of credit your situation changes. You’ll still have $1,000 in your savings account and your line of credit will be down to $4,000 of debt. This still leaves you with a net worth of -$3,000. However, now your interest payments are just $23.
You’re saving $41 dollars per month which you can put towards paying down the rest of the debt, or other things you need. Meanwhile, if an emergency comes up, you can pull any money you need back out of the line of credit so nothing is lost.
This is what I’d do with reusable debt, like a line of credit. With vanishing debt, like a personal loan or mortgage, I’d be more conservative with your money and leave a cushion in your savings account. Vanishing debt is usually at a lower interest rate and won’t be quickly accessible if you need to withdraw more money.
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