Use Savings to Pay Off Debt

If you have extra savings and debt, you should weigh whether your savings are better used to pay off debt. The baseline comparison to make is what it will cost you to pay off the debt through installment payments verses what the equivalent principal is earning you in interest.

Ideally, this comparison is made on a tax-adjusted basis by comparing effective interest rates of your debt and the tax-adjusted interest rate on your investments. The effective rate on debt is the true cost of borrowing, which would include all closing costs, fee, points, etc. that is then adjusted for any tax deduction (ex. on a mortgage).

For example:

If you had $10,000 in savings and were earning 5 percent annually in a non-qualified (not tax advantaged) account -- you would earn $500 in interest before taxes. If you were in a 25 percent tax bracket, you would pay $125 in taxes and keep $375.

If you also had $10,000 in credit card debt and were paying 20 percent interest -- you would be paying $2,000 in interest per year.

In this example -- it is clear that you would want to pay off your credit card debt with your savings. You would save $1,625 annually in interest by paying off your credit card debt.

Even if you took out a home equity loan at 8 percent annually to pay down your debt and were able to fully deduct the interest payment (making your effective rate 6 percent) -- you would still be making $600 in interest payments annually, so it would still be better to pay down the debt.

The basic rule of thumb is to pay off debt that has a higher interest rate than what you earn on your investments.