See two examples that show why you should pay off your high-interest credit cards before you build your emergency reserves.
One of the most common questions I would get when talking to people who were at the very beginning of getting their financial life in order was this: if I have credit card debt and no savings, should I pay off the debt first or build emergency savings?
To most, it seems like a tough question. But, the good news is, it is really pretty straightforward.
Pay off high-interest debt first. Build emergency reserves later.
There are two ways that I like to think about this. I have been using these examples for years, and I have found that one or the other way clicks for most people. So, if you don’t really groove with the first one, that’s okay. Try the second!
Your Available Credit Is Your Emergency Reserve
The first way I like to answer this question is to say that you already have an emergency reserve… just not a very good one.
The difference between your credit limit and your current balance on your credit card is your available credit. Whenever you make a payment, you decrease your current balance and increase the available credit. If you get into financial hot water before you have the card paid off completely, then you have the option to use the card. You should only do this in the case of an emergency… which I guess qualifies this available credit as an emergency reserve!
However, as we all know, this is not a very good emergency reserve because if you use it, they’ll charge you a bunch of interest.
But, they’re charging you interest now! So, by that same logic, you should pay off your credit card debt first. Then you can build a better emergency reserve with an actual savings account.
What Would You Do If I Handed You $1,000?
The second way I like to answer this question is to imagine that I hand you $1,000.
What would be a better use of that $1,000? Put it into savings or pay down your credit card?
Right now, the average interest rate on credit cards in the US is almost 18% according to the CreditCards.com weekly report (published July 24, 2019). Just to make the math a bit simpler, lets round that up to 20%.
If you put that $1,000 toward paying down your credit cards, you will reduce the amount of interest you pay in the next year by $200.
If you put that $1,000 into a savings account, you will not.
Why would you spend an extra $200 on interest if you don’t have to? That’s just silly. Pay off your high-interest credit cards as fast as physically possible.
No matter what your goal is financially, any high-interest credit card debt you have is standing in your way. Get rid of it as fast as possible, and never allow it back into your life.
Then, when you have no credit card debt at all, you can get to work building your emergency reserves.
I hope this has been helpful! I welcome your comments with your thoughts and questions. And, don’t forget to subscribe to the newsletter to get notified whenever a new article is posted.