Ask Stacy: Do I Keep My Savings or Pay off Debt?

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Here’s an interesting question I recently received… I hope you’re all in the same situation!

Hi Stacy,
I’m torn between taking a large sum of money I’m currently holding to pay off some loans. I’m currently making monthly payments and will have the loans paid off in two yrs. I would be debt free if I paid everything off but I just feel secure having the large sum. What do you think?

– Cecil

At first blush, this is a simple question with a simple answer: If you’re paying more in interest on your debts than you’re earning on your savings, the math demands that you pay off the debt. For example, if you’re earning 1 percent on your savings and paying 15 percent on your credit card balance, you’re walking backwards to the tune of 14 percent! This is obviously not wise.

Sounds simple enough. Only an idiot would keep money in a low-paying savings account while simultaneously paying a much higher rate on a loan, right? Maybe, but if that’s true, there are a lot of idiots in the world, including yours truly. I have enough money in a laughably low-yielding money market account to pay off my mortgage. And yet, there it sits. Why?

Well, let’s examine my motives and perhaps at the same time offer a little advice to Cecil.

Reasons I’m keeping money around rather than retiring debt

  • I might need it. As I mentioned in another recent post (Ask Stacy: Why Aren’t You Buying Stocks?), I think real estate is a bargain right now and I might want to buy more. I also like to have some cash around in case I see other investment opportunities – that’s how I was able to invest in stocks near the bottom of the market a couple of years ago, and it’s possible that I may want to buy more. (See my personal portfolio.)
  • The interest on my debt is tax deductible. Tax-deductible interest lowers the effective rate you’re paying. For example, my mortgage interest rate is 4.75 percent, and I’m in about a 30 percent tax bracket. This effectively reduces my after-tax interest by 30 percent: So rather than paying 4.75 percent, I’m actually paying 3.325 percent. However, that’s still a lot more than I’m earning on my money market account – which leads us to the real reason I’m keeping so much cash…
  • It feels good. This Cecil will understand – I suspect it’s really the reason he’s asking this question. But it may be harder to grasp for those in less fortunate circumstances. The truth is that when you live a frugal life for decades and finally wake up one day to find yourself sitting on a fat bank account, it’s a very, very nice feeling. Sure, the math commands you drain that bank account and satisfy those remaining debts, but you don’t care. It’s like having tons of food in the freezer, or having your files organized, or your laundry done, or your house clean. Feeling safe, secure, and flexible is good. I’d recommend it to anyone.

When it comes to money, we like to pretend the answers are all objective. It certainly makes life easy for advice-givers like me: If you’re earning X and paying Y, do Z. But let’s be real. The answers to many questions about money involve more than math. Cecil and I should both be aware that keeping money in a low-interest savings account while paying higher interest on a debt comes at a cost. It gradually reduces your net worth. But it also gives you peace of mind. And that’s something that’s hard to put a price tag on.

Bottom line? Do the math – but then do what feels good.

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  • http://www.facebook.com/people/Angela-Morales/1527344847 Angela Morales

    Very cool answer. I had to make a similar decision, butt I opted to pay off my mortgage. Still feels good. It’s one bill I don’t have to see again and I can use the interest saved to build up my savings. Scary at first, but I know I can do it.
    Thanks for the info.

  • Sam Ziadeh

    What I have done is take half of my savings and pay a bill or several bills. Example, if you have 10k in savings, and have 15k in CC debt, you are paying 537 a month (if it is all on one credit card with min payment of 2%). If paying off 10k in CC debt now you will pay only 358 a savings of 179 a month that he could put towards either the CC or back into savings. Using the save X amount divide it by 2, and start over works wonders on how much debt you reduce, and how much faster you save each time debt is reduced. Thankfully the only debt I have now is my mortgage.