Why Pay Off Credit Card Debt Before Building An Emergency Fund
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Editor’s Note: The APYs listed in this article are current at the time of publication. They can fluctuate (up or down) based on changes in the Fed’s rate. CNBC will update as changes are made public.
Emergencies are inevitable, and once they happen, you’ll want to have the means to cover those expenses and protect yourself from a financial setback. This is why experts advise people to put money aside in a emergency fund, especially when job security is at the forefront of Americans’ concerns.
“My theory comes down to money – saving money,” Krawcheck said CNBC Select. Credit cards charge high interest rates, so cardholders are actually paying to borrow money when they have a balance.
For example, our best credit card with cash back, the Signature Alliant Cashback Visa® credit card, charges a variable APR from 12.24% to 22.24%. For those with average credit, the Capital One® QuicksilverOne® Cash Rewards credit card offers a flat variable APR of 26.99%.
“Every day that your high interest debt goes unpaid, it costs you money – LOTS of money – in interest,” says Krawcheck.
Instead of putting your extra cash in an emergency fund, she suggests that focusing all of this on credit card debt first will save you more money in the long run.
Let’s take a look at a hypothetical example that shows how fast credit cards compound interest increases your unpaid debt:
If you had a credit card balance of $ 6,194 (The average credit card debt of Americans) and were billed at an interest rate of 15.78% (the average credit card APR according to the The most recent data from the Federal Reserve), by paying only $ 200 per month for this debt, it would take you over three years to fully pay off the credit card. During that time, you would spend $ 1,812 on interest only, bringing your total to $ 8,006 ($ 6,194 + $ 1,812).
However, that’s better than the alternative, argues Krawcheck: if you instead used that $ 200 monthly payment to create an emergency fund from scratch in high-yield savings, like the Varo savings account with an APY of 1.21%, three years would net you a total of $ 7,336 less, not to mention that you would still be in debt.
“You might as well take the money you save and throw it out the window,” Krawcheck says.
Plus, paying off your credit card debt improves your credit rating because it lowers your credit utilization rate (CUR). The lower your usage rate, the better your credit score because it shows that you are not using all of your credit and paying it back. Credit usage represents 30%, or one-third, of a credit score on the FICO model.
So while the general rule is to have three to six months of savings before going into debt, remember that the interest will cost you in the meantime.
While building up an emergency fund might make it look like you’re doing something right, it instills a false sense of momentum if you lose money to interest on your credit card for the next day. do, says Krawcheck. Saving can be important if you’re worried about losing your job and paying for priority invoices, but it will cost you more over time.
To feel a positive momentum when paying off that debt, Krawcheck suggests keeping an index card in your wallet and ticking off when paying off some of the debt. And if you have a sudden emergency, use a credit card to pay it off. This way, you incur high interest on an outstanding balance for a much shorter period.
Alliant Cashback Visa® Signature credit card and Capital One® QuicksilverOne® Cash Rewards credit card information was independently collected by CNBC and was not reviewed or provided by the issuer prior to publication.
Editorial note: Any opinions, analysis, criticism or recommendations expressed in this article are the sole responsibility of the editorial staff of Select and have not been reviewed, endorsed or otherwise approved by any third party.