Should I Use Saved Money to Pay Off Debt?
Often times we think to ourselves, "If I was debt free, I would..." Or we do some mental math in our head that generally supports the argument of using our saved money to pay off our debts. We pace back and forth for a few days and even ask or tell our friends about the idea only to come to the conclusion that ultimately it is your choice and your choice alone.
So what are some of the things to consider when deciding to pay down debt with your savings?
What type of savings will you use?
There are different types of savings vehicles that one can tap into to pay off debt. One could use their emergency fund money which is typically found in a savings account or a secondary checking account away from their primary bank. You could use savings that you've been accumulating for another goal like a vacation, a big celebration, or a major purchase. These funds are also found in a checking or savings accounts or maybe even a taxable investment account.
As a last resort, retirement accounts such as 401ks, 403bs, IRAs, or Roth IRAs can be used. These are not my favorite accounts to tap into for debt repayment because retirement, whatever that looks like to you, is an inevitable event that is mainly paid for by you and the decisions you make in the interim.
What are you giving up when you use each type of account?
The obvious is you will be taking away from the goal you are saving for. If you take from an emergency fund, then you lower the amount of funds you have in case of an emergency. Yikes! If you take money from an account meant for other goals such as vacation, a big celebration, or a major purchase, then you either erase the goal or kick it down the road. And of course, if you take from a retirement account, you lower the amount or empty your retirement account. What's the big deal right?
Well there are other costs to consider when taking money from an investment or retirement account.
If you will be using money from an investment account, you will have to pay capital gain tax on stocks you sell to acquire the needed funds. Capital gains is the difference between what you bought your investments for and what you are selling them for. If it has been less than a year, then you pay short-term capital gains which is whatever tax bracket you fall in. If you have held your investments for longer than a year, then it could be anywhere from zero to twenty percent.
However, if you will be using a retirement account to pull funds from, instead of capital gains tax, you are taxed as if you earned the income if the retirement account is a pre-tax account. This is not the case if you use a Roth account, since it is tax-free. There is an additional stipulation for retirement accounts though. Generally, if you take money from your retirement account before turning age 59 1/2, you have to pay an additional 10 percent penalty for the distribution. Maybe this is a deal breaker, maybe it is not...
The one thing people do not take into consideration when taking money from their investment accounts, whether it is a retirement account or a regular taxable account, is the potential for growth. This could be a huge cost in the long-run! Especially if you are going into retirement because your investments are what will keep you from outliving your money and keeping up with inflation.
What type of debt are you paying down?
There are different kinds of debt; revolving debt, fixed loans, long-term, and short-term debt. Revolving debt is the worst. It has high interest rates and keeps accumulating interest on outstanding balances. If you pay the minimum on this kind of debt, it will cost you big time in the long run. Fixed debt, whether it be short-term or long-term, is easier to decipher. One can look at the fixed interest rate they are paying to compare the alternative of keeping their money where it is. Which will earn you more? If you pay down an interest rate of four percent, it is similar to saying your investment earned four percent. The lower the interest rate on your debt, the more I would be inclined to make the payments instead of paying a debt off.
What will you do with the extra cash flow?
This is the money question. What will you do after you pay X, Y, or Z? You will have more cash at your disposal. If it is just for the sake of being debt free, then figure out how long it will take you to replenish your savings to the level you were at plus an interest you are comfortable with if you use an investment account; pay yourself back. If you are wanting to clear a debt to have cash flow for something else, then you may have to rethink what is more important, "new goal" vs. "the goal you are taking money from?"
The Bottom Line
At the end of the day we all want to know, are we better off? The answer to that question comes down to a matter of choice. The choice is never easy, the answer is never truly right, there's just your situation and what you feel comfortable with. However, having a financial plan doesn't hurt to see the long term effects of your decisions.
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