Stockpiling Cash vs. Paying Off Credit Cards
People in debt may be wiser than experts think
You don’t need a Ph.D. in finance to appreciate that carrying a credit card balance that charges a high interest rate is costly, especially if you have cash you could use to pay it down.
Yet a recent experiment by the Consumer Financial Protection Bureau (CFPB) suggests that Americans have a lot of other risks to consider when making the decision to save or reduce debt.
The CFPB presented participants with six scenarios in which someone had enough savings to pay off their credit card debt in full. Yet in five of the scenarios, fewer than half of participants chose to use all the savings available to wipe out expensive debt.
And nearly eight in 10 people in the CFPB experiment showed they were well aware credit card interest rates are higher than savings rates.
The balancing act of high-cost debt and high cash-flow anxiety
Academics refer to this behavior as “the credit card debt puzzle.” Sure, in a dry economic analysis, available cash should be used to pay off the debt. But there are other things to worry about:
—Bills keep coming even when you lose a job.
—A few medical tests — let alone ongoing care — and the deductible and co-pay can quickly run a couple thousand dollars.
—And in little more than 12 years the country has been rocked by two massive economic recessions. The reasons for the Great Recession and the ongoing pandemic fallout are obviously different, but their impacts are similar: Household cash flow was stretched by job loss or reduced income.
Some guidance when weighing whether to pay down debt or stockpile the cash:
Ask for a rate reduction. Slowing down the growth in your balance means you ultimately will need less cash (savings) to pay off the credit card bill. If you have been managing to avoid late card payments (even if just the minimum due), there’s a solid chance that your credit card issuer might be willing to reduce the interest rate you’re charged. A survey a few years ago found that eight in 10 people who asked for a break, got one. And the average rate cut was a sizable six percentage points.
Carefully consider the right savings goal for your household. Having savings that can cover at least three months of living costs is the popular recommendation. To be safe, you should consider adding the cost of your annual health insurance deductible as well. A three-month cushion plus health insurance deductible is indeed reasonable if your work is relatively immune to layoffs or disruption. Teachers, doctors, nurses, for example. But if you work in a more economically sensitive field, having six months of living costs saved up is a goal to consider. To simplify: Would that six months make you sleep better? If the answer is yes, then that’s the right move.
Don’t over-save if you have credit card debt. While many households struggle to have enough savings, there are some that have an overly large chunk of cash sitting in the bank. Again, your sleep-at-night comfort is important, but if you have excess savings and also carry high-rate credit card debt, your behavior is indeed a bit puzzling. Pulling some cash from a bank account that pays less than 1% interest to get rid of debt that costs you 16% is a guaranteed instant 15% investment return.
Keep medical debt off your credit card, when possible. Deductibles and co-pays are a common reason people have credit card debt. If you have a medical bill you can’t pay in full, don’t reflexively put it on a credit card. Tell the medical provider you can’t pay the sum, and then start negotiating. Your provider doesn’t want to send your bill to a medical debt collector (where they get only a fraction of the amount collected, if any), and thus may be willing to accept less upfront from you, or offer an installment plan.
Squeeze some extra cash flow out of your spending. There are plenty of strategies for reducing spending. Every dollar not spent is another dollar that can be tossed into the demanding juggle of building a savings cushion and paying off expensive credit card debt.