Paying off debt with your safety net

Get rid of high-interest debt as quickly as possible, but don't sacrifice your financial security to do it.

Question: Conventional wisdom says you should pay off your credit card debt as quickly as possible. But does that mean I should use my cash reserves to pay it off? Or should I just continue paying as much as I can (currently about $800 a month) to whittle it down? Problem is, if I pay off the debt with my emergency fund, I’ll then no longer have a fund for emergencies. What’s your suggestion? --Shirley, Ely, Nevada

Answer: This is one of those situations where neither of your choices is particularly attractive. If you use your cash reserves to erase your credit card balance, you will have no cushion to fall back on if you’re laid off, hit with unexpected bills or have to come up with quick cash for some other reason.

If you don’t pay off your card balance with your cash reserves, then you’re in the position of paying a high rate of interest on your plastic debt - just over 13% is the average - while at the same time you’re probably collecting only 2% to 3% on the investments that make up your emergency fund (savings accounts, money-market funds, short-term CDs).

If you were making this decision on the basis of the numbers alone, you would clearly be better off dipping into your emergency cash reserves to pay off your debt. After all, why hold onto assets that are paying only 2% to 3% when you can use them to rub out an obligation that’s costing you upwards of 13%?

But I don’t think it’s wise to view this issue in the narrowest financial sense. Indeed, if you come at it that way, no one with a home mortgage would have an emergency fund either, since the rates on home loans are invariably higher than those on cash-like investments.

Instead, I think you’ve got to approach this in terms of what makes sense in the real world. And, in the real world, I believe you need an emergency reserve that can act as a buffer against the uncertainty and vicissitudes of life.

So while I agree that it generally does make sense to get rid of credit card debt as quickly as possible, I think in this context “as quickly as possible” means the quickest you can do so without jeopardizing your financial security. Which means paying off your plastic as rapidly as you can from current income.

This approach also has another advantage, although it might not seem like one at first. Extricating yourself from this predicament by wiping out your credit card debt in one fell swoop with other assets almost gets you off the hook too easy. You could come away with the idea that the consequences of running up debt aren’t that severe. You just find some other assets to pay it off - your reserves, your 401(k), maybe funds in another account - and poof! Your problem disappears. No unpleasantness. No pain.

But having to pay $800 month after month to your credit card company is a pretty good constant reminder of the pitfalls of letting your credit card debt (or any debt, for that matter) get out of hand. Presumably, having to shell out that kind of money puts a crimp in your lifestyle, perhaps even forces you to make painful choices. But maybe that’s just the incentive you need to assure you don’t put yourself in this position again.

Of course, if you can pay more than $800 a month, you’ll pay off your debt faster. To see how increasing your monthly payment by $50, $100 or whatever amount can shorten your pay-off time, check out the calculator on Bankrate.com.

A lower interest rate on your debt would also help you zero out your balance more quickly. So you might see if you can transfer your balance to a credit card that carries a lower rate. You could also consider paying off your credit card balance with a home equity line of credit that has low closing costs, assuming you qualify for one. Aside from probably lowering your rate, switching to a home equity line would also likely make your interest tax deductible.

But while moves like these can help, ultimately resolving this issue comes down to whether or not you have the discipline to make it happen. So pay as much as you can toward that credit card debt, and once it’s gone, don’t run it up again.