Building up savings is great. But if the money in your savings account is offset by credit card debt, it's a case of taking one step forward and several steps back.
That's because credit card debt costs much more than savings accounts earn.
How much more?
To answer that, you can look at the interest rate you're paying on credit card debt. Then look at the rate you earn on your savings account.
Chances are, you'll see a large gap between the two interest rates.
Average Interest-Rate Gap Widens to 16.88%
Based on credit card data from the Federal Reserve and savings account data from the FDIC, the gap between the average rate charged on a credit card balance and the average rate earned by a savings account is 16.88%. (That's up from 13.62% just five years ago.)
That gap represents the amount many are paying over and above what they can earn on savings - and why it makes sense to use savings to pay off credit card debt.
A poor to mediocre credit score can make the gap wider too. So using savings to pay down your credit card debt can be a very cost-effective move.
What About My Emergency Fund?
Financial experts agree that it's a good idea to have an emergency fund saved up to handle unexpected expenses or a loss of income. So what if paying off credit card debt means spending down your emergency savings?
A big reason for having an emergency fund is to avoid going into debt when you have a financial setback. However, if you are already in debt, there is less point to keeping that money in reserve.
Perhaps one reason for not using your emergency fund to pay off debt would be if you are concerned about losing access to credit in the future. In that case, you may want to consider some of the alternatives for paying off credit card debt discussed below.
However, if your credit problems are that bad, you need to work on improving your credit score. Paying down debt could be Step 1.
To be clear, using savings to pay off credit card debt should not extend to tapping into money you have in a 401(k), IRA or other qualified retirement fund. Doing that before you reach age 59 1/2 would cause you to pay taxes and penalties on the money you take out.
Alternatives for Paying Off Credit Card Debt
There are alternatives to paying off credit card debt that don't involve tapping into savings. However, these should be viewed as short-term solutions that only make sense if they are part of an overall plan for paying down debt in the foreseeable future.
1. Zero-interest balance transfer credit cards
One solution is a zero-interest balance transfer card. These credit cards let you transfer an existing balance and pay no interest on the balance for a temporary period.
Two things to watch out for with balance transfer cards are fees and the interest rate you would eventually have to pay after the zero-interest period ends.
Here's what to look for:
- Low or no balance transfer and annual fees
- Competitive ongoing interest rate if you plan to continue using the card after the zero-interest period
>> Balance transfer credit card offers - read tips on the fastest say to get out of debt with a balance transfer card
2. Personal loans to refinance credit card debt
Another alternative is to refinance your credit card debt with a personal loan. This won't eliminate your interest costs, but it could reduce them. Personal loan rates are generally a lot lower than credit card rates.
If you consider a personal loan, make sure to shop around to find a rate that can really save you some money. Also, take into account any fees when you compare the cost of a loan to your current credit card rate.
The reason balance transfer cards and personal loans should be considered a short-term alternative is that they don't eliminate your debt. They just lower your cost on that debt.
Lowering your cost is good, but eliminating it comes down to budgeting so you can pay off your debt for good. Then you can use those budgeting skills to take the next step of building up savings.
Paying Off Credit Card Debt is Just Step 1
As mentioned above, paying down credit card debt can be Step 1 toward improving your finances. Doing so can eliminate costly debt and improve your credit score.
However, this first step should be just the beginning of a larger program that you plan to work on over time.
Pursuing additional steps beyond paying down your credit card debt could help you avoid getting in that kind of debt trouble again in the future.
The good news is that, once you get rid of those costly interest payments on your credit card debt, it should be easier to take the next steps of budgeting and building up savings.
Step 2 - Rein in spending with a budget
The next step is to work out a budget that reins in spending.
After all, the point of paying down that credit card debt should not be simply to make your credit limit available again for further spending. You need to address the habits that led you to build up debt in the first place.
Keeping track of your spending is a good place to start budgeting. You can then compare your spending to what you are earning and decide what spending can be eliminated. Keeping your budget within your means can help you make larger monthly payments that reduce your debt.
Step 3 - Rebuild savings
It may take a while; but once you have a handle on your budget, your next move should be to rebuild savings. Not only can it come in handy to have a reserve of cash in case of emergencies, but you need to start thinking about how to store away some retirement savings.
Building up for retirement savings can be quite an uphill battle if you're burdened with credit card debt. Using savings to pay it off is one way to approach the problem. Balance transfer cards and personal loans effectively lower the cost of credit card debt so you can free yourself of the problem sooner.
Whatever your choice, the goal is to put debt in the rear-view mirror so you can make reaching retirement a little easier to attain.