I have $10K saved and $9K on my credit card. Should I use my savings to pay off my credit card debt?

Here's a hypothetical but eminiently relatable situation: Let’s say we have a friend named Dante who is debating this question. He has $10,000 stashed away in a savings account for emergencies, but currently owes $9,000 in credit card debt. He would like to be debt-free, and wonders if it would be best to pay everything off all at once or throw every penny of his disposable monthly income, around $2,000, toward repaying the debt.

Both may be viable options, but here’s what he needs to consider first.

Paying off the credit card now

If Dante paid all of his credit card debt immediately using his emergency fund, he would save himself from paying any further interest, but he would also leave himself exposed.

Being left with $1,000 in savings, it could take only one emergency expense to derail his finances and put him back in debt. Dante could begin putting his disposable income toward his savings, but it might take several months before he feels comfortable again.

Benefits of sticking to a savings plan

Assuming the interest rate on Dante’s credit card debt is 20%, and he spent $2,000 per month paying it down, he would be debt-free in just five months, paying about $450 in additional interest. A relatively small, but not insignificant amount added to what he owes.

But despite paying hundreds of dollars in added interest, by maintaining his emergency fund, Dante has shielded himself from going further into debt from any unexpected expense. In this case, he bought peace of mind.

How to set up an emergency fund

Your emergency fund should be accessible enough that you can withdraw money on short notice, but not so accessible that you can just dip into it on a whim.

• Consider opening a high-interest savings account. Compare interest rates and fees. Make sure it’s convenient for transferring or withdrawing money in a hurry.
• Eliminate the need for self-discipline or willpower. If your employer pays by direct deposit, divert a portion of your earnings to the savings account. If you deposit your paycheques into a chequing account yourself, set up recurring transfers to the emergency fund.

You might choose to put your emergency money into guaranteed investment certificates (GICs), which pay higher interest. But there are pros and cons, because those are designed to be long-term investments.

Banks and credit unions typically charge penalties for cashing out GICs early. The penalties can encourage you to leave your emergency savings alone, but you'll be missing out on the flexibility of a high-interest account — and take a financial hit if and when something happens and you need to tap into your money.

A middle ground

Dante’s $10,000 savings is healthy, but it isn’t quite enough to qualify as a full-fledged emergency fund. Many experts recommend setting aside three to six months’ worth of expenses in case of a large unexpected expense or job loss.

But if he’s comfortable with risking some of it, for now, he can seriously cut down on the amount of added interest he pays on his credit card debt. If Dante put $5,000 of his savings toward the debt, along with $2,000 per month, he could be debt-free in just over two months and only pay about $100 extra interest. He could then, almost as quickly, rebuild his emergency fund and keep it growing afterward if he so wishes.

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Bank of Canada (1); KOHO (2)