Dear New Frugal You,
Right now I owe $3,100 on my credit card. I have $6,000 in my savings but am trying to hit a benchmark of $10,000 in my savings. The way I've been saving I should hit the $10,000 mark in three months. However, the balance on my credit is glaring. My total credit limit is $4,500. Should I pay this debt immediately, slowly, or should I continue to pay a small amount just over minimum to hit my benchmark of $10,000, then anything I make after will be strictly towards my debt? Please and thank you. -- Waqas
Dear Waqas,
Congratulations on your savings success. I'm sure that it feels good to be so near to your goal. Your question is a good one and one that many people ask: Does it make sense to put money in a savings account while you still are repaying debt?
Let's look at the question a couple of different ways. First, we'll discuss why we want/need a savings account and why we borrow money. Second, we'll look at the purely mathematical aspects of your question. Then, finally, we'll consider some of the emotional/psychological issues your question brings up.
I'm guessing, but I suspect that you started saving because you became tired of having unexpected expenses that could be paid only by using your credit card. And, to tell the truth, those bills aren't really unexpected. We know that a car or the fridge will break down or we'll need to visit the doctor. What we don't know is when it will happen.
As to why we use credit cards the story is usually the same. In the beginning, it's just convenience. They're easier to use than cash. Plus they're handy for the unexpected bill that we can't handle out of savings. Typically we want to spread the bill over the next few months and pay down the credit card account.
Sometimes we find that difficult to do. And today's unexpected expense gets added to the one from six months ago that we still are working on repaying. So our balance doesn't disappear, but rather seems to be growing. That sounds like what you're experiencing, Waqas.
Next, let's examine the math of the question. If you're asking what's the quickest way to both save $10,000 and repay your debt, your answer will lie in the interest rates. Compare the interest rate being earned on your savings to the interest rate being charged on the credit card. You should put any extra money you have on whichever is higher.
It's almost certain the credit card bill should be paid off first. Your interest rate on the unpaid balance is probably in the teens. Your saving account is probably in the low single-digit range. Once you've paid off the credit card you can resume adding to the savings account.