Douglas Rice, DBA is an assistant professor in the School of Business and Management.
It’s quite common to have both a savings account and a credit card balance, as the money in the savings account provides a sense of security. The debt is seen as a different thing that is either ignored or avoided when thinking about personal wealth. This is generally a bad idea. Here’s why:
Net worth is one number – When you calculate your net worth you simply add up your assets and subtract your liabilities. So if you have $1,000 in savings and $1,000 on a credit card, your net worth is zero. You may feel like you have a $1000 in the bank, but what you really have is nothing. Looking at your net worth as just assets and not liabilities may make you feel better, but it can lead to making poor financial decisions.
Debt is leverage – Debt magnifies the price change in the asset purchased. If you buy dinner and a show on a credit card, you are paying interest on the debt and therefore the cost is higher. If you buy an asset that appreciates on credit, then the gain is greater. This is one reason why people love the idea of real estate, because when it goes up the return on the initial investment gets magnified due to the loan on the property. Of course, everyone also now knows that when it goes down, the losses are magnified. So if you acquire debt, make sure you've bought something that will go up in value. Avoid those that go down in value or go to zero.
Cash flow is like a bucket of water with holes in it – It's an unusual analogy, but if you consider money coming in as filling the bucket and cash leaking out when you spend it, then filling the bucket faster than you empty it increases your wealth. If you are earning 3% interest on a savings account and paying 18% on a credit card, your bucket has a 15% hole in it and you need to plug it. Paying off the credit card would stop the leak.
But before you make any moves, there’s a few more things to consider:
- Can you restrain yourself from running up the debt again? If not, you could be setting yourself up for failure as you might end up actually spending more.
- Will you need the cash for an emergency such as a potential job loss? In recessionary times, access to a substantial amount may be worth a bit of interest. You never know when your credit will be restricted. This happened to many homeowners who thought they had home equity lines of credit for emergencies, but when the emergency came, the bank cut them off. Is the savings earmarked for something specific, like a down payment on a house or college tuition?
- Is the savings in a long term investment plan? Is it in a tax deferred account like a 401k or IRA? Penalties are going to be stiff and while the numbers may still work out, tapping into retirement accounts shouldn’t be taken lightly. Try to pay down the debt with income.
- There may be more situations in which savings, even with some credit card debt, is acceptable. So think through your situation before you act.
For many people, dipping into savings will stop the cash flow drain and improve your financial situation. But there are times where cash is king and it’s nice to have some handy. Consider your situation and make the best decision for you.