Debt Planning: Should You Pay off Your Debts With Your Savings?

This is a question that we hear a lot: should I use the money in my savings account to pay off my debts? The answer is a typical lawyer's response (sorry!): yes and no. Helpful, right? Just give me a minute to explain.

First the ‘yes.’ Yes, you can use your savings money to pay off some debt if you have already established an emergency fund. Now the ‘no.’ No, you should not use your savings if you do not have an emergency fund.

Have an Emergency Fund First

The first rule of thumb for any financial planning is to have an emergency fund that will protect you in case an emergency arises. Obviously, the amount in your emergency fund will differ depending upon your unique circumstances, but it should be enough to get you by for at least three months with no income.

As your circumstances change, you should increase the amount of your emergency fund.

How to Use Your Savings Effectively

Once that is settled, you should begin to use the extra funds to pay off debt -- as long as you put any money saved back into your savings account.

But which method will work best for you? Should you pay off the cards with the lowest interest first or the cards with the smallest balance? Which ones is more effective? This is truly a personal choice and you will really need to look at two things.

Example: After you have set aside an emergency fund and after you have used some available savings to pay down other debts, you are left with five (5) debts. First, you need to focus on the debts themselves. Make a list of all your creditors. In the next column put the total amount owed. In the next column, the interest rate for each creditor, and in the last column the monthly payment. For example:

  • Visa $2500 12% $200
  • Mastercard $1500 19% $125
  • Amex $3500 17% $150
  • Capital One $7500 22% $335
  • Doctor Bill $75 N/A $15

There are several schools of thought when it comes to paying down debt. The first school of thought says to pay off the debt with the lowest balance and create a snowball effect. So, in the example above, once the Doctor Bill is paid off, the $15 per month would be applied to the Mastercard payment. Once the Mastercard payment is done, then you would add $145 to the Visa payment and so on.

The second school of thought is to pay off the account with the highest interest rate. In the example above, that would be the Capital One and then focus on the next higher balance.

That said, it’s a good idea to try one strategy and see if going that route is a) financially bearable b) makes you feel like you’ve accomplished something important. In the end, debt planning really is all about how you feel once you have paid off some debt. Just like anything else in life, the method that you choose should feel right to you and your lifestyle.