Many articles have covered the crossover point – the point where earnings from investment income exceed living expenses, so that you can theoretically stop working for an income and instead just live off of your investments – detailed extensively in the book Your Money or Your Life.
At some level, the crossover point is the reason all of us work and save – so that, one day, we can do what we want instead of what we have to do to live. There’s also a new calculator to calculate your own crossover point. If you’re lucky, you’ll hit that point at or before you plan to retire – if you’re not, you may have to work past retirement age or figure out a way to spend less.
Over the last few weeks, I’ve been contemplating what to do about a different kind of crossover point – the point at which liquid savings exceeds debt. I give informal financial advice to a number of family members and friends. At least two are at or near the point where the money they have in savings (not retirement or investment accounts, but cold, hard, earning-1%-or-less cash) exceeds the amount they have remaining to pay in debt. They can use the savings to become debt free – but ultimately be left with an empty bank account. Alternatively, they can continue to pay the debt in monthly installments – racking up more interest but also able to breathe a little easier about their cash cushion.
Some scenarios are very easy – if you’re paying off debt at 15% or higher and you have cash in savings that you have absolutely no need for, pay off the debt! The cases where it becomes really hard to decide whether to use savings to pay off debt are the ones in which there is no clear cut answer – the ones where the debt is a car loan or student loan at 6% interest or less, and the cash is earning 1-1.5% in savings or CDs. Yes, mathematically you are losing money each month you continue to contribute to savings instead of paying off debt. But it still might make financial sense over the next few years to go ahead and keep the cash. For instance, if you have an old car, you might be saving your cash for maintenance and/or a new car. Depending on your age, you might need the cash for upcoming big purchases like a house, wedding, your child’s college payments or a retirement cushion. If your job safety is a little shaky, you might want to hoard cash as a super emergency fund in case of a layoff. While hardcore followers of Dave Ramsey would say that you should NEVER have cash savings that exceed your debt balance, the reality is that for a variety of reasons – it happens.
Steps to Evaluate Payoff
When people ask me if they should use savings to pay off debt (or, for that matter, to make a large retirement contribution or similarly tie up the funds), this is the general advice I give them. Note that this assumes that you have made a commitment to stop incurring new debt and are generally trying to become debt free!
- Run the numbers. Then run them again. What debt do you have remaining, and how high are the interest rates? Why exactly are you saving cash, and when do you plan to spend it (creating your own dollar plan can help with this step)? How much cash do you have right now, and how much can you add to it in the months or years before you need it (remember that you can add the funds you were previously using to pay off debt)?
- Pay off high-interest debts no matter what. Simply put, it makes no sense to continue to pay interest rates of 12-15% or higher if you have the money to pay off that debt – many credit cards fall into this category. If you have the money in savings to knock out these balances in full, do it. Unless you need the cash in the next 4-6 months, you can probably find a way to replenish it before you need it – take on extra shifts at work, cook a little extra at home, etc.
- Keep no-interest debts for the time being. Conversely, it makes no sense to pay off a 0% loan early as long as the 0% rate will continue until the loan is completely paid off. Pay the minimum on these debts until you either pay them off or have absolutely nothing left to do with the cash you have on hand.
- Use the funds you don’t need to pay off debts, highest interest first. Say you’ll need $10,000 in two years for a house down payment, and can contribute about $2,000 a year to your savings account. That means you only need $6,000 right now – so if you have $7,000, you can use $1,000 to pay off debt. Start with your highest interest rate debts in order to save the most on interest. But if the interest rates are all within a few percentage points and you can knock out several small debts with your excess savings, you might want to do that instead.
- Continue paying remaining debts monthly. If you can’t pay off your debts with your unneeded cash, keep paying using whatever methods you were before – snowball or some other. If you can curtail adding to your savings account in favor of paying off debt faster, even better.
- Repeat every 4 – 6 months. Simply put, things change. In a few months, you might find you need less cash than you originally thought, and you can erase more debts. You might get a raise and be able to hit savings goals faster, freeing up money for debt payments. Or you might find out that layoffs are coming, you need a bigger cash cushion, and you need to slow down debt payments to rebuild your cash reserves. Regardless, repeating this exercise every few months will ensure that you pay the least amount of interest on your debts while also maintaining enough cash to meet your needs.
Now it’s your turn – would you liquidate savings to pay off debt? What if you knew you might have big expenses coming up? And a related question: should you pay off debt now even if you might have to incur more later (such as for graduate school or a financed car)? Or keep paying interest now to build up savings and avoid paying interest later? Tell me why in the comments!