Wednesday, October 1, 2008

In this corner: Debt reduction...In this corner: Savings

I know that many financial experts recommend paying of debts - especially high interest credit card debt first, before saving. Conventional wisdom suggests that paying off high interest debt garners an immediate 13%, 18%, 21% (or whatever) rate of return on your money. Makes sense. I guess.

Here's the problem. If you take all of your available cash and pay down debt, then what will you do in case of an emergency? (eyes on your own paper) Right! You'll go into debt - whether it's putting the charge on the same credit card which now has more room, or borrow it from your next door neighbor, along with a cup of sugar. Kinda defeats the whole purpose, no? On top of that, the emergency will actually cost you more in the long run, because of the interest you'll pay, and the fee that it may cost you to use your credit card. For instance, some utility companies and insurance companies charge a transaction fee for paying with a credit card.

Sometimes the emergency is a mini emergency where you can't pay with credit. Your transmission goes costing more than the available credit you have on your Visa. Some random field trip comes up at your child's school and the nitpicking teacher doesn't take American Express. Not to mention that your goal in life is to dig yourself out of debt, and continuing to charge feels like running up the down escalator. What's a debt-buster in training to do?

I say: Split the difference. I find it a bit more psychologically comforting to save some money for emergencies, even if you are paying off debt. To my mind, it works the same way as the debt snowball. The debt snowball, class, is a method of repayment where you pay off the smallest debt first, regardless of interest rate. Once you have success in eliminating the first debt, you get a psychological boost and roll the former debt payments into paying off the next debt on the list. Psychologically, a good idea. Financially, not so much. But sometimes the process is not as crucial as the end result.

I have come up with a highly complex and intricate formula: 75/12.5/12.5. When a windfall, a
debt snowflake, or a debt drizzle comes, (a debt drizzle is that tiny drop of rain you feel that falls from the leaves of trees, after the real rain has stopped), when such money comes, I take 75% of it and put it towards debt. I divide the remaining in half - thus the 12.5% - and put it towards savings. For me, that means 12.5% goes to my ING emergency fund -towards the requisite 6-months, minimum, that we all should have, and the other 12.5% goes towards regular, WTF, did my check engine light just come on?!? -savings.

For me, even though the savings may come in more of a drip than a gusher, it is comforting to see the balances limp along. Little by little, they will begin to pick up steam and break into a fast walk, a trot, a sprint, and finally-- a full on run that would make Usain Bolt proud.
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Diane Scott said...

The whole idea is to save, save, save while paying down. And yes, you are most certainly right, just about the time you think you're on track and maybe just maybe getting head, WHAM! However, you still must stay the course or what will one's future look like? Even cat food costs an arm and a leg these days!

Single Mom, Single Money said...

Amen. I guess I'd better keep saving. Although Fluffy find it delicious, I'm thinking I probably wouldn't enjoy having to share a bowl of Friskies with her in my golden years!

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