Credit Card Debt & Savings

People struggling with credit card debt often face the dilemma of saving versus paying down credit card debt. Theories regarding which option is best abound. While building up an emergency fund is important, paying down debt is also essential. When deciding on the best course of action, there are a few things to consider.

The Interest Trap

Current interest rates for savings and other investment accounts, such as CDs and bonds, are very low. Conversely, credit cards and other unsecured debt carry finance charges of up to 29.99 percent. Many financial analysts are advising consumers to pay down debt first due to the low interest rates on savings accounts. Tom Adams of Adams Financial Planning advises clients to pay down high interest credit cards first before trying to build up savings.

Paying Debt with Savings

Although controversial in nature, many analysts suggest using savings to pay down high-interest debt. ABC News consumer correspondent Elisabeth Leamy says consumers can make an instant profit by paying high-interest debt with low interest savings. For example, a credit card balance of $10,000 that carries a 17 percent interest rate yields a savings of $1,500 when paid off with a savings account that yields 2 percent. This is calculated by the credit card interest of $1,700 minus the savings account interest of $200.

Which Debt Should Be Paid First

Analysts may differ in their opinions of savings over debt but they agree that the higher interest rate credit cards should be paid first. This is because over time, the consumer pays more for these cards. There is a psychological effect of paying the smaller cards first because the consumer gets a boost when seeing a card paid off. But advisors warn that savvy consumers shouldn't fall for this and by paying off high interest cards first the balances will be reduced quicker.

The Importance of Savings

Despite the advice of paying debt first and foregoing savings, it is still important to have some sort of emergency fund. The fund should have at least $1,000. Taking this precaution will help prevent the use of credit cards in the event of an emergency, such as car or home repairs. Once the emergency fund is built up, then extra payments should be funneled into paying off credit cards. If you are contributing to a 401(k) account through your workplace and are receiving matching funding, it is not prudent to stop contributing in favor of paying off debt. A 401(k) match by a company is free money toward retirement and should not be passed up.