At some point in the process of attempting to get out of debt, most people will ask themselves an important question: Should I use savings to pay off debt?
The answer is a complex one, because there are several variables in play.
The most obvious consideration is whether or not you have enough liquid savings to pay off your credit cards, or other debts.
Even if you do, is it a wise move to wipe out all of your savings to pay off debt?
Types of Debt: The Good, the Bad, and the Ugly
I’m not fond of any debt, in particular, but will admit that some debts are worse than others.
I’d put owing the IRS back taxes right up there with owing a loan shark money as ranking the highest in “ugly” debt.
Trust me; you do not want to owe the IRS money.
If you find yourself owing them a ton of money, try to raise the funds or borrow the difference from another source.
Things like credit cards and car loans fall in the “bad” debt category, because they are usually attached to depreciating assets. Have you ever borrowed money against a car or a credit card for anything that went up in value? I didn’t think so.
On the other hand, some may consider debt attached to real estate, or modest debt used to finance an advanced education as “good debt.”
After all, mortgages generally allow homeowners to purchase an appreciating asset that should eventually be worth more than the cost to finance.
Types of Savings
Much like there are several different types of debt, the same goes for savings. I put savings into three large buckets:
- Short-term savings for immediate needs (my car insurance premium, real estate taxes, etc.) in sinking funds
- Long-term savings for big goals (college educations for my children, a newer vehicle, etc.)
- Retirement funds (Roth IRAs, 401ks, etc.)
Types 1 and 2 can be broken down further into liquid funds and non-liquid assets. The easier it is to convert an item to cash, the more liquid it is.
Cash savings is the most liquid, and something like equity in a home may be the least liquid (after all, you’d have to sell your home to receive these funds, without tapping a home equity loan).
Now that we’ve established the various types of debts and savings, you can make a more informed decision about using savings to pay off debt.
If you can comfortably pay off all of your bad or ugly debt, without generating fees or taxes, and be left with a solid 3 – 6 month cash emergency fund, you should pay off your debt.
On the other hand, if paying off debt with savings would leave you complete wiped out of a cash reserve, it is not advisable.
You would find yourself in a precarious position: debt free with no savings. If you had even a minor emergency, you would be right back in debt.
A compromise may be to use a portion of your savings to jump start your debt payoff plan.
Consider taking 50% of your savings and paying off as many debt accounts as you can, starting with the smallest balance and working your way towards the largest balance.
Then use the amounts you used to pay on those smaller accounts to pay down larger debt.
This is often referred to as a debt snowball plan, and it is how our family became debt free in two years.