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Reduce Savings to Pay Debts?

The Dollar Stretcher Blog
by Gary Foreman

Hello Gary,
I retired early from my job of over 30 years and am now receiving a pension.  I have an outstanding car loan with a balance of about $2500.00 at 4.49% interest. I have a Home Equity loan with a balance of $27,000 at 5.95% interest. I received a bonus from work when I retired for unused sick leave that netted me about $9,000. I put it all in an online savings account as a Contingency fund.  I just received notice that it is once again dropping the interest paid on my savings to 1.39%!
My goal was to finally have an emergency fund with $10,000 in it.  I am so close, but with the paltry interest being paid is it better to just rid myself of this car loan once and for all with my savings money?  That would leave me with only the home equity loan as debt.  I could then contribute more money each month to accelerate paying that off earlier.  I live a very simple and frugal lifestyle and feel very fortunate to be able to receive a pension in this day and age.  However, I would love to be free of this debt anchor.  Paying the bills and this debt on half pay is proving to be quite a challenge. 
Thank you.

You ask a very good question. And, it's one that a lot of people are asking. With interest rates being so low, does it make sense to leave money in a savings account while you're still paying on debt.

There are really two ways to look at it. The first is from a purely dollars and cents point of view. In that case you'd calculate how much interest you're earning in the savings account. Then you'd calculate how much interest you're paying on the auto loan. And, then compare the two numbers. If you're paying more in interest than you're earning, you'd pay off the loan. Typically that's the case.

The other way to look at it is to look beyond the interest earned and charged. You might consider: do you have additional flexibility by leaving the money in savings? Do you feel more secure knowing that you have money in savings? Is there some other reason that you expect to want the money in savings later?

Or it could be that you feel better knowing that the debt is reduced. Maybe you're afraid that money in savings will disappear in wasteful spending if you leave it sitting there.

Let's look a little closer at Charles' situation. First, the interest earned and charged.

You could do a lot of fancy math, but you can get a pretty good estimate if you make a few simple assumptions before you start calculating.

What's the difference between the two interest rates? In this case it's about 3% (4.49% minus 1.39%). We could complicate this by asking whether they're both APR's. Or even considering whether either is taxable. But, that's not really necessary. We're not shooting for absolute mathematical certainty here. Our goal is to just get an idea of how much money were talking about.

OK, so there's a difference of about 3% between the cost of the car loan and what you're earning at the bank. How does that translate into actual dollars?

The outstanding car loan amount is ($2500). So that's how much we're talking about. But we can't simply figure 3% of $2500. That's because the car loan will decrease as you pay it off. Suppose that it takes 2 years to pay off, that would mean that it would be about 1/2 that amount (or $1250) midway through the loan. Higher at first, and lower later.

So in effect it's like borrowing $1250 for the 2 years. It's not exactly mathematically correct (the loan actually goes down slower at first and the rate of decrease goes up near the end of the loan). But it's close enough for our purposes.

So it will cost Charles 3% of $1250 for 2 years to keep the money in savings. Or about $75 in extra interest (3% X $1250 X 2).

Now Charles has some information to help him make his decision. If the knowledge that you have the money in savings is important to you then it's worth $75 to keep it in savings. But, it's probably not a life/death decision on either side.

One other thing that Charles might want to consider is whether he can earn more on his money at another bank. One we've found that generally pays well is ALLY < >.

You can use this same strategy to evaluate repaying almost any loan. Figure out how much money is involved and multiply by the difference in interest rates and the amount of time involved. Then take a look at the other factors to decide what's best for your situation.

Keep on Stretching those Dollars!

Gary Foreman is the editor of The Dollar
<> and newsletters <>. Not only does the site host thousands of articles on various ways to save money, but you'll also find a vibrant forum where people share their dollar stretching ideas. You can comment on this entry here
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