In the world of frugal living, there’s one question that often pops up: should I put extra money towards credit card bills or save it? The answer isn’t always straightforward, as personal financial situations vary.
However, there are compelling reasons to prioritize paying off credit card debt. In this article, we’ll explore the benefits of putting extra money towards credit card bills, using insights from various expert sources.
The High Cost of Credit Card Interest
One of the primary reasons to focus on paying off credit card debt is the high interest rates that credit cards typically charge. According to CNBC, credit cards can have interest rates as high as 29.99% variable APR. This means that every day your high-interest debt goes unpaid, it’s costing you a lot of money in interest.
Compound Interest: The Debt Snowball Effect
Credit card interest compounds, which means that the interest you owe is added to your balance, and then you’re charged interest on the new, higher balance. This can cause your debt to snowball over time, making it even more challenging to pay off. CNBC provides a hypothetical example that demonstrates this effect:
- An average credit card debt of $6,194
- A 15.78% interest rate (the average credit card APR according to the Federal Reserve)
- Paying only $200 per month towards the debt
In this scenario, it would take over three years to pay off the credit card, and you would spend $1,812 in interest alone. Your grand total would be $8,006 ($6,194 + $1,812).
The Opportunity Cost of Not Paying Down Debt
By not prioritizing credit card debt repayment, you’re essentially throwing money out the window. As Sallie Krawcheck, CEO of Ellevest, puts it: “Every single day your high-interest debt goes unpaid, it’s costing you money — a LOT of money — in interest.”
The Emergency Fund Dilemma
While it’s important to have an emergency fund to cover unexpected expenses, delaying credit card debt repayment to build up that fund may not be the best strategy. In the hypothetical example mentioned earlier, if you used your $200 monthly payment to build emergency funds from scratch in a high-yield savings account with an APY of 1.20%, you would have a total of $7,336 after three years. However, you would still have the credit card debt, which would continue to accrue interest.
Improving Your Credit Score
Paying down your credit card debt can also improve your credit score. One of the factors that affect your credit score is credit utilization, which accounts for 30% of your FICO score. By paying off your credit card debt, you lower your credit utilization rate, which can lead to a higher credit score.
The Rule of Thumb: Saving vs. Debt Repayment
The general rule of thumb is to have three to six months’ worth of savings set aside before tackling debt. However, it’s essential to consider the cost of interest while building up your emergency fund. In some cases, it may be more financially prudent to pay off high-interest debt first.
Balancing Savings and Debt Repayment
While the above points make a strong case for prioritizing credit card debt repayment, it’s crucial to strike a balance between saving and paying off debt. Bankrate’s emergency savings report found that only 43% of Americans would be able to cover an unexpected $1,000 expense from their savings, and one-quarter would need to accrue credit card debt to pay for such an expense.
When to Make Saving a Priority
There are some situations where focusing on saving may be more beneficial than paying off debt:
- Debt with a very low interest rate
- Access to an employer 401(k) match program
- No emergency savings
When to Prioritize Debt Repayment
In some cases, it makes sense to focus on debt repayment before building up savings:
- High-interest consumer debt
- Minimum payments on debts with high interest rates
Strategies for Balancing Savings and Debt Repayment
To strike the right balance between saving and paying off debt, consider the following steps:
- Calculate your expendable income
- List your regular expenses
- Create a budget based on your income and expenses
- Identify financial goals and add them to your budget
Debt Repayment Options
When it comes to debt repayment, choose a strategy that works best for you:
- Pay off your highest-interest debt first
- Pay off the smallest debt first
- Pay off the debts that most affect your credit score
Debt consolidation may also be a good option if you have multiple high-interest debts.
Age-Based Savings Goals
Having age-based savings goals can help you stay on track with your emergency fund and retirement fund. These goals will vary depending on your personal financial situation, but setting targets can help you maintain a balance between saving and debt repayment.
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The Bottom Line
Every individual’s financial situation is unique, but in many cases, paying extra money towards credit card bills can lead to significant long-term benefits. By reducing high-interest debt and striking a balance between saving and debt repayment, you can improve your financial health and set yourself up for a more secure future.
