Should I Pay Down Debt or Build Up My Savings?

Generally, you should pay down high interest debt first

Dear BLR Editor,

I’m due to receive about $3,000 from selling some of my musical equipment.  I’m 25 years old and I have a good job, but I also have a car note, at 4.5% and $26,000 in credit card debt.

My instinct tells me to save this money in my rainy day account, which is currently only about $3,600 in scattered accounts.  However, my head tells me to pay down debt.  What do you suggest?

- Shawn


Editor – Thanks for your question, Shawn.  Today’s economic environment is infused with a lot of economic uncertainly and you are not alone in wanting to build yourself an emergency fund.

The problem with contributing all this money to an emergency fund is that you’ll receive only 1-3% interest on a CD or money market account.  If your credit card debt is at 15.4% or even 19.9%, then your money would work harder by paying down debt.

Let’s put it this way: look at your accounts (debt and savings) as one pot.  If you pay off debt at 15.4%, it is equivalent to getting 15.4% on a savings account, which is better than 1% (for a CD).

Do contribute regularly from each paycheck to your emergency savings account and if you feel it is perilously low, save a bit from this expected sale.  However, remember also that same credit card can be used for emergencies if you haven’t maxed it out.

So my vote is pay off your credit cards with most or all of the expected cash.  Once you’ve done so, your car is next.  I wish you the very best.