So you have a little extra cash on hand at the end of the month—should you use it to pay down credit card debt, or add it to your savings account? The answer depends on a lot of factors unique to your personal financial situation. To make the right choice about what to do with extra money, take the following questions into consideration:
Do you have enough money set aside in case of emergency?
Most financial experts recommend that you keep an “emergency fund” large enough to cover three to six months of living expenses. Your emergency fund should be kept in a savings or a money market account that you can access without penalty, but won’t be tempted to touch unless you absolutely need the money.
What’s the interest rate?
Get out your statements from savings and investment accounts, as well as your credit card bills. What are the interest rates? Interest rates have plummeted over the past several years, so that many savings accounts and money market accounts are earning next to nothing. On the other hand, you may be paying interest on credit card debt as high as 20 percent. You should pay down debt with extra money, unless you can find an investment vehicle that offers a higher interest rate.
Savings: If you put $100 in a savings account earning 1 percent interest, you’ll have $101 in a year. But you’ll owe taxes on that extra $1, so your real rate of return is actually less.
Debt Reduction: If you pay off $100 of debt on a credit card that charges 18 percent interest, you’ll save $18 and owe $100 less.
Why not do a little of both?
If you’re not sure whether to pay off debt or add to savings, why not do both? Use half your extra money to pay down the debt with the highest interest rate, and invest the other half. When it comes to your money, it doesn’t have to be all or nothing.