I have a problem. Is it smarter to have money in an emergency account or use it to pay off debt? Here's the situation: I have $6,500 on my Capital One card. I don't use the card anymore. It's old debt from a stupid business decision. I have saved almost exactly $10,000 in my savings account and enough in my checking account for bills but not much more. What would you do with the money? – Anita
I'd consider your predicament to be more of a puzzle than a problem. With a positive net worth, you've got spare funds to manipulate.
The golden rule with emergency savings is that an individual ought to have at least three months' worth of necessary expenses tucked away. Because you'll want the money easily accessible and not be charged penalties for early withdrawal, it shouldn't be in something like an individual retirement account (IRA). A savings or money market account is the best home for cash you'll need in a crisis.
To know how much you'll need, calculate the cost of housing, groceries, transportation and other key expenses. If they run about $2,000 per month, you'd want about $6,000 in the emergency fund. That sum would cover those expenses in case you lost your job and needed time to find another. If other people are depending on your income for their economic security, add another month's worth of those expenses for each additional person.
You'll still want to pay your debt down quickly, too. You don't say how much you're currently sending in each month, but, if it's just the minimum, you're losing out. Assuming an interest rate of 20 percent, the finance charges alone could be around $100. Hold up a $100 bill and gauge your reaction to setting it on fire. If the thought makes you feel ill, I suggest you use a portion of your savings to delete all or at least a large part of your balance.
Here's what I think you ought to do:
1. Determine how much you really need to have for emergencies. Set that figure aside for a moment.
2. Withdraw half of what's in your savings account ($5,000) and apply it to your Capital One card. That should leave you owing just $1,500.
3. Figure out how much you can send to the bank each month. Pay that constantly, until the debt is gone. If you can manage $300, you'll be in the clear in five months.
4. Once your card has a zero balance, take whatever you've been sending to the credit card company and reroute it to your emergency savings. Remember that desired figure from step one? You'll want to hit it.
5. When you've rebuilt your emergency account, start setting cash aside for other things, like retirement, vacations, hobbies and clothes — whatever you like. Money is to be enjoyed, as long as you have no debt obligations and enough tucked away for emergencies.
After you pay your debt off, your credit score should also improve. But don't neglect it. Keep your credit rating high by using your card regularly and responsibly. A good credit report and score will come in handy if you ever want to finance a new car or buy a home. So identify one thing in your budget that you can charge and then pay in full every month.
There's the answer to your debt versus savings “problem.” At least on paper — now you have to actually do it!
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