I graduated from law school almost three years ago and until June 1998, I didn't have a real full-time job. I am now working. I have some savings that I hope will go toward a house, but I also have about $40,000 in law school debt and about $15,000 in credit-card debt that I aggressively "flip." Aside from my 1998 taxes, I haven't added to the debt. Do I continue to save or pay back debt? Do I use savings to pay off the debt or continue to invest it?
-- Meyer Y. Silber
Unfortunately, there isn't a universal answer to this question. The answer depends on your situation and, to some extent, your stomach for debt.
Ideally, you want to get rid of the debt that is tied to the highest interest rate first. I'll assume you have a good interest rate on your law school loans, so paying them back on a monthly basis is probably a good deal. So let's concentrate on getting rid of your credit-card debt.
"Until you get out of credit-card debt, you can't breathe. It's like a drowning rat," says Marilyn Steinmetz, a certified financial planner with
in West Hartford, Conn. I know you're trying to save for a house, but until you get rid of these credit cards, a mortgage is only going to make your debt situation worse.
There are advantages and disadvantages to using your savings to pay off your debt. We'll look at both sides of the issue.
First, you need to assess how much stress being in debt is causing you. If you can't sleep at night because you count credit-card bills instead of sheep, then just pay the debt off. "Having debt can suck away your control, so the sooner you get out of it, the better," says Carmen Petote, a certified financial planner and president of
Allegiance Financial Advisors
If that's the case with you, cash in your savings or borrow the money. Do what you must. Who cares what the financial planners think if you're stressed out? Take care of your head first.
If you're not a basket case about your debt, before you deplete your entire savings, make sure you have a something set aside for emergencies.
"You need some kind of reserve so you don't go back into credit-card debt again," says Deborah Voso, a certified financial planner and president of
in Frederick, Md. Three months' worth of living expenses is recommended. If you're living at home after law school, you may not need that much. "If you're driving around in a car that's held together with rubber bands, you might need more," says Petote.
But what do you do with the rest of your savings?
Here's another financial planner guideline: If the interest rate you're paying on your credit-card debt is higher than the interest you're getting on your savings, it might make sense to use your savings (less your emergency fund) to pay off that debt.
Don't use those introductory, "teaser" credit-card rates when making this calculation. It's great that you're "aggressively flipping" your credit-card balance around to take advantage of low interest rates, but if you run out of low-rate "teaser" deals, you could get stuck with an interest rate as high as 20%.
Even if you're making more on your savings than you're paying in interest on your debt, there are other factors you need to consider. If you're invested in stocks or mutual funds, your return will fluctuate with the market. Today it may be a good return, but who knows about tomorrow?
You also should be aware of the cost of pulling money out of your savings. If you pull money out of a mutual fund or sell some stocks, you will be subject to capital-gains tax on the difference between your original purchase price and the fair market value of the shares on the day you sell. So when calculating the return on your savings, be sure you're looking at your aftertax return.
Now let's say you're in a worst-case scenario. Your savings don't equal the three months' worth of expenses you should have in an emergency fund, and you still need to pay off your credit-card debt. Which need do you address first?
Here's another good gauge: Use about two-thirds of your free cash (after paying your bills) to pay off your credit-card debt and put the balance into a savings account, suggests Voso.
Credit-Card Flipper's Tip
If you're like Meyer and you move your credit-card balances around a lot, make sure you get a copy of your credit history report. Here's why.
Just because you move your balance out of a credit-card account doesn't mean the account is closed. If you move your money out of an account with, say, a $10,000 credit limit, that $10,000 still will show up on your credit report as available credit to you. So if you apply for a mortgage, the bank will see that you still have the ability to charge $10,000 on that old credit card, and it will consider that potential debt. That could hurt your mortgage approval.
So if you're no longer using a credit card, call the company and cancel the account. And if you've had so many accounts your can't keep track of them all, get your credit report.
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