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Should You Use Savings to Pay Off Debt?

Recently a close friend and I discussed a debt she wanted to payoff. She has a car loan with a balance of about $10,000 at an interest rate just north of 5%. It’s killing her that she’s paying interest on it and wants to know if she should pay off the loan with her savings.

Mathematically, if she’s earning less on her savings account than she’s paying in interest on the car loan, it makes sense to pay it off.

However, there’s a factor that isn’t considered in that equation. It’s the liquidity of money. The money in her savings account, could be used in an emergency. Payoff the debt [1] and she can’t go back and get the loan in an emergency.

As we discussed emergency savings [2], she asked about the six month rule of thumb for emergency savings. A rule of thumb is often thrown out when people ask how big should your emergency fund be? [3]

I rephrased the question to her this way. “If you and your husband lost your job today, how much money would you want in the bank?” Her answer, was exactly what she has right now.

The interest on the car loan appears to be money she’s throwing away. However, in her case, it’s actually an insurance policy against unemployment or other emergency situations. When we looked at it that way, she was much happier!

Some of us operate strictly on mathematical formulas (I usually fall in this group), some of us operate completely on emotion. But most of us are somewhere in between. The real key is finding out where on the spectrum you fall and aligning your financial decisions to that sweet spot.



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