simple budgeting question

January 5, 2009 10:35 AM

If you earned $2500 a month after taxes, and you paid about $1000 on rent/bills/groceries/fun, how much of the remainder would you pay toward a credit debt of $6000 at 9% and how much would you put into savings at 4.5%?
posted by anonymous to work & money (29 comments total)

Do you have a six month (preferably twelve month) emergency fund? If no, devote all money except minimum payment on the credit cards and rent/bills/groceries/fun to that fund. If yes, devote all money to the credit debt. There's no reason to put money into savings when the interest rate is lower than your interest rate on your credit card.
posted by saeculorum at 10:38 AM on January 5 [3 favorites has favorites]

I would put everything I could into paying off the debt.
posted by jedrek at 10:39 AM on January 5 [5 favorites has favorites]

Well, I'm not going to spin my wheels crunching numbers to optimize your financial plan without knowing more detail, so I'll say, just offhand, that I would simply drop $1000K on the debt and $500 in the savings. when the credit card debts are under 10% of their maximum balances, start putting $1000 on savings and keep the rest to pay of rotating balances or as a general cushion fund in checking.
posted by Ambrosia Voyeur at 10:39 AM on January 5

Well, once/as you pay off the credit card debt, are you just going to pile more on? If those are your habits, then be sure to save some money as well as paying off the debt. Say 30% saved, 70% paying off debt.

If you're sure you're not going to get into more credit card debt, I'd focus on paying it off before saving. Although you might want to save some for a bit of piece of mind, say 10/90 or something similar.
posted by yellowbinder at 10:41 AM on January 5

You don't need to crunch any numbers.

9% > 4.5%.

There is absolutely no economic benefit to doing something like Ambrosia Voyeur suggests. The one exception is with an emergency fund, as I've previously stated.
posted by saeculorum at 10:42 AM on January 5 [4 favorites has favorites]

I like the simple: 50% needs, 30% wants, 20% savings.

That's 1250/mon on "needs" like bills, groceries, and rent
750/month on "wants" (usually things like booze and whatnot, but for this case, debt-repayment is your primary "want")
500/mon goes to savings.

Yes, it sounds weird, but your debt doesn't have a huge interest rate. In all honesty, I'd fudge these numbers a tad. I would move some from the savings column into the debt-repayment column.

Make sure you have at least $1000 in savings, too. This will help in emergencies.
posted by phrakture at 10:45 AM on January 5

Though if you don't cancel your cards, then you do have an emergency line of credit which you can use if there is a true emergency. The key is to plan what you would consider a 'true emergency' - car repairs? a flight to the bedside of a loved one taken ill? or a great sale on a new North Face parka? or dinner out with your college friend who you never see any more?

As long as you are clear on the very limited circumstances that would be considered emergencies, you can devote all your cash to paying down the card limits. You'll pay less in interest overall, and even IF you later do have an emergency, you'll have been paying interest on a lower balance until those charges appear, so you still come out ahead of where you would have been with a cash savings fund.
posted by Miko at 10:46 AM on January 5

I agree with Ambrosia Voyeur. Pay the majority towards your debt and contribute to savings as well. I read a financial advice book that recommended this, in that people like you (and me) are often tempted to forego savings in order to pay down debts, but in a couple of years they still won't have paid off credit cards and won't have anything at all in savings. Besides, it's never a bad idea to have a thousand in savings, just in case you need to get a new apartment/fix your car/ get laid off, etc...
posted by emd3737 at 10:52 AM on January 5

Yes, it sounds weird, but your debt doesn't have a huge interest rate.

No, but the interest rate is twice as high as the rate he gets on his savings. It makes no sense to put any money in the savings account at 4.5% when there is a credit card debt at 9%. Every penny should be used to pay off the debt.

As someone else stated, the only exception would be for an emergency fund in case of, uh, emergency.
posted by Justinian at 10:54 AM on January 5 [3 favorites has favorites]

There is absolutely no economic benefit to doing something like Ambrosia Voyeur suggests.

Yeah well, there's a lot more to a good financial plan than the math. Our personalities and habits matter too. Without knowing more about the poster's longterm financial needs, or whether accruing interest of 9% is a crucial concern to him (it may not be), I would keep advise a simple plan that is unintimidating and easy to stick to.
posted by Ambrosia Voyeur at 10:56 AM on January 5

Me too. I think "pay everything towards the credit card debt until it is gone" is about as easy as it gets. But then I virtually never carry a balance on a credit card in the first place so maybe I'm atypical.
posted by Justinian at 10:58 AM on January 5

people like you (and me) are often tempted to forego savings in order to pay down debts, but in a couple of years they still won't have paid off credit cards and won't have anything at all in savings.

This seems to presume that one either can't pay off the debt at all due to its size (in which case bankruptcy is an option), or that one won't change one's spending habits. I ran up a large credit card debt, then paid it all off and stopped carrying any debt at all on my cards. You should never carry debt on your credit cards. If it's important enough debt to incur it at all, you can almost certainly get a better deal with a line of credit or financing.

That said, second those above for whom contributing to savings at a lower interest rate than your debt's is stupid, except for the purpose of establishing a basic emergency fund. You should always have at least a month's expenses in cash available, preferably more.
posted by fatbird at 11:00 AM on January 5

If you will not be feeding a credit card habit, put it all into paying down the card.
posted by tkolar at 11:02 AM on January 5

I don't understand why you would want to save anything for an emergency fund when you are wasting money on the credit card debt. If there is an emergency use the credit card.
I can't think of a situation other than fleeing the country where I would need everything in cash.

/This advice only applies if you aren't going to mess up and start running up a lot of money on the credit card just because it's paid off. If you need to have money in savings so you won't spend it then put money in there as well.

Also, reading this: "rent/bills/groceries/fun":
Take out that "fun" expense until your credit card is paid off. You should be able to pay it all off within 4 months depending on how much you're spending on "fun."
Maybe eat some ramen for awhile too.
posted by zephyr_words at 11:18 AM on January 5 [1 favorite has favorites]

I agree with Ambrosia Voyeur's assessment, it's advice I wish I had followed in my twenties. Start getting in the habit of putting a minimum into your savings now.

What you should remember, IMO, is that you're likely to continue to accrue debt. If you don't put anything into savings, when you finally pay off your debt, it suddenly becomes a tempting idea to make a sizable purchase on your CC, thinking, "Oh, I'll pay it off with the money I'm no longer paying toward my debt."
posted by mkultra at 11:19 AM on January 5

First rule of holes: once in one, stop digging. If you're continuing to spend money you don't have - which is what credit purchasing is - then any of these plans are more or less pointless.

Presuming you're now bringing in less than you're sending out, I'd say that if you have 0 emergency fund that you should 50-50 your credit card paydown/emergency fund building. While you could theoretically use that credit for your emergency spending it's just a bad practice and reinforces poor habits.

Also, not everything can be paid for by credit card, so relying on it for emergency money could require you to pay cash advance fees/rates. Once you have 2-4 months in expenses saved (which won't take too long if you really put 750/750 into debt/savings and have monthly expenses of 1000) you could shift to something more like 75/25 for debt/savings.

It galls me as a cheapskate to say it, but really if your debt/expense/income is what you describe it as then I think the most important thing you can do is build a habit of savings and cash spending. It's a shame to enrich someone else to the tune of 9% a year, but at this point you've already made the mistake of deciding to pay $1.10 for something that cost $1. It's more important to never make that mistake again than it is to minimize the penalty for this past mistake.

Even if you only use 33% of your discretionary monthly income - $500 - you'll be debt free in 13 months and you'll have paid just under $300 in interest. Double that to $1000 a month and you're paid off in 6 months and paid $158 in interest. The savings diminish further in going to $1500 and being done in just over 4 months.

That $150 is a pittance compared to your lifetimes savings of making new habits.
posted by phearlez at 11:22 AM on January 5

Depends on whether you're going to use the credit card at all before it is paid off. If you're like most people, payments on the credit card will be offset by new purchases. In that case I'd pay the minimum payment only (leaving less of a temptation or ability to spend on the credit card), save the rest until you have enough to pay off the card completely, then do it all at once.
posted by blue_beetle at 11:32 AM on January 5

This is an easy one. You should be putting every penny except for rent and bills towards paying down your debt. $6k is a big number, especially if your cash flow is only $30k a year. If you pay off $1500 a month, you'll be paid off in 4 months. That means by summertime you are debt free.
posted by charlesv at 11:49 AM on January 5

Nthing getting an emergency fund if you don't have one already. Your first month, pay the minimum on your credit card and the rest of your discretionary $1500 to your emergency savings, which would be a little over a month of regular living costs. Then, starting in month two:

- If your job seems reasonably secure and you're covered by unemployment insurance, put everything you have toward the 9% credit card and it will be paid off before summer. Your next goal: a 6 month emergency fund now that you are completely debt-free.

- If your job may be a little precarious, but you are covered by unemployment insurance, try to grow your emergency fund to 2 months, paying the the rest to your credit card. Again, once your CC debt is gone, grow your emergency fund to at least 6 months of emergency living costs.

- But if your job is really iffy, or if things are bad in your part of the country even though your job seems OK for now, or if you are not covered by unemployment insurance (don't assume that you are just because you get a paycheck -- be sure!), pay just the minimum toward your credit card and the rest to savings until you have 6 months of emergency living costs. This doesn't necessarily mean that you need to save $6000 before paying more than the minimum on your credit card. There are probably several ways you can trim your budget even further if and when you hit a true financial crisis. If the shit hits the fan, you can cut or drop cable entirely. If you have a land line and a cell phone, you can cancel one of those. You can eat more vegetarian meals at home with your friends and eat out a lot less. So your 6 months emergency fund may actually be closer to $5000.

I hear what everyone's saying about simple math. The interest rate on the credit card is twice as high as what you earn in interest. And if you put aside 2 or 6 months of emergency funds, you have just delayed paying off your credit card by that amount of time. But if you do lose your job, or get hit with large unexpected expenses, you will have immediate cash to help you out, with no interest charges at all when you're already dealing with a lot of stress. As phearlez mentions, credit cards may not cover all needed expenses, and cash advance rates can be horrible.

But I think there's also a big psychological difference for most people when they start saving purposefully. Get the appropriately-sized emergency fund for you in place, take a breather and knock out the debt, then create a new savings plan once your debt is gone. I think you'll be less likely to rack up that kind of credit card debt again once it's paid off.
posted by maudlin at 12:03 PM on January 5

I would do everything I could to build up a 3 month emergency fund, pay off the debt, and then increase my savings to 6 months worth of expenses.

The rules I'd lay down are: no more eating out until I've built up 3 months and paid off the debt, no more shopping with a credit card - cash only, no more nice-to-have things, only necessities, etc.

The reason you ought to have 3 to 6 months worth of expenses in the bank is to self-insure yourself against unforseen problems that would put you in a much worse financial situation, such as: losing your job or getting injured, leading to you not being able to cover your rent, leading to you having to find a new place under duress ...
posted by zippy at 12:50 PM on January 5

You should favorite all the previous comments that say to not put money into savings until the credit card is paid off. The credit card is your emergency fund if you need it. Once it is paid off, start building a true emergency fund.

All other answers will cost more money in the end for no added benefit.

OK, now go pay off your credit card!
posted by qwip at 1:13 PM on January 5

For all you people nay-saying the "put money in savings too" plan, because the math works out: You fail to realize that overspending and debt don't just happen because of math. It's the broken axel on your car, or the new 50" TV you just "need". This is what the money in savings is for - to protect you from the things which are just going to pound you back into debt when you get it somewhat paid off.

Hell, don't take it from me. Take it from a guy who is way richer than all of us combined. Notice how a lot of his "here's how you fix this" stuff flies in the face of all your math. The debt snowball system is, in fact, very much wrong in the eyes of mathematics.
posted by phrakture at 1:21 PM on January 5

Check out daveramsey.com. Going by his plan (99.9% of it), we got out of debt and have stayed out of debt. Also, we feel confident that running our finances the way he recommends, we will stay out of debt. We've been doing it for over 5 years and been debt free for 4 (except the house). It is a very real-world common sense method.
posted by atm at 1:25 PM on January 5

1) A credit card is not an emergency fund because a credit card is not your money. A credit card is a promise to loan money to you, up to a specified amount, for a specified interest rate. The credit card company may change the interest rate or the credit limit pretty much at will. I have heard of some companies dropping the credit limit as the account gets paid down. Theoretically, if you have $6000 to sock away over the next 4 months, and you choose to put every penny of it toward a credit card without making an emergency fund, you could wind up with an "emergency fund" of a loan of up to $500 at 15% interest at the same time that you lose your job and no longer have any money coming in.

2) A credit card is not an emergency fund because most people will find that they cannot pay rent or mortgage through their credit card. They may not have a high enough credit limit to pull out a cash advance to cover these costs, and even if they do, the interest rate will be higher than 9%.

The OP has accrued some $6000 in debt over an unspecified period of time. That's a serious amount of debt, so paying it off quickly is important. But if their financial situation is relatively secure, it will take them just one month to put aside $1000 of THEIR money in THEIR savings account. If they pay the leftover $500 to the credit card that same first month before they start paying $1500 a month for another 4 months, that should take care of their debt completely. Creating a small emergency fund first means that they may pay a few more dollars in interest in the long run, but they will have interest-earning cash on hand to pay rent if the worst does happen. And if they are in a more precarious situation, with no unemployment coverage and/or a threatened job, building a proportionately larger emergency fund should take priority over saving the difference in interest.

If you rent or own your house or apartment, you probably pay a small amount each month for insurance, just in case there's a fire or a burglary. You may also pay extra each month for health or disability insurance. If you have dependents, you pay life insurance. You could argue that you will probably stay unburgled, uncrisped, healthy, able and alive for the next few months, so why not cancel those regular bills, too, so that you can throw every available dollar at CC debt? A liquid emergency fund that you are in complete control of is just another kind of insurance. You pay some extra money in CC interest charges by sending some money to an appropriately sized emergency fund, but if you need that fund, your own cash is much, much preferable to getting deeper into debt, assuming that the credit card company is even willing to loan you the money you need at any interest rate.
posted by maudlin at 2:08 PM on January 5 [2 favorites has favorites]

Think about it like this:

My brainmath puts your monthly interest only payment at roughly 275 bucks (that amortizes as you pay down your debt of course). If you can pay that off in 4 months rather than 6 months, you'll save probably 300 dollars, which is far more than the measely 4.5% you'll be accruing on your savings account.
posted by stratastar at 2:40 PM on January 5 [1 favorite has favorites]

I formerly was of the opinion that in a situation such as what you describe, the proper method was that you completely pay off your debt, and THEN you save. My theory was that if you were let go, you could use the credit available on your credit card as an emergency fund.

This is not a wise move because, as pointed out, there are utilities that don't accept credit cards, including, usually, rent. I now find myself in that precise situation I speculated about. Had I no cash reserve, my only option would be to take out usurious cash advances from my credit cards. Fortunately, I had something, and also unemployment, of course.

My own advice would be this.

Look at your utilities. Come up with a number that is the total monthly cost of your bills that don't accept credit cards. Multiply that by six or twelve; in these times, frankly, I would multiply by twelve.

The result of that math equation should be the amount of money to which you divert all but your bills and credit cards' minimum payments.

Once you've done that, pay off your credit cards as quickly as possible, and take measures to heavily cut down your monthly expenses to maximize the amount you can put into those cards.

Then, once your credit has been cleared off, keep the credit lines open until you have saved up a six- (or twelve-) month emergency fund in cash.
posted by WCityMike at 6:05 PM on January 5

Take the 4 months, pay off the debt, then worry about emergencies.
posted by ikkyu2 at 8:28 AM on January 6 [1 favorite has favorites]

Funding an immediate $1000 emergency fund (if none currently exists) beats paying off the credit card first.

Assume an opening balance of precisely $6000, including accrued interest, on the January bill. Anonymous can either:

1) Pay off in 5 months: Pay $1500 each in January, February, March, and April and the remainder in May to zero out the credit card. (If they can squeeze a few extra bucks out of their budget, this could be 4 months because the final payment is only about $63.)

2) Pay off in 5 months after creating a small emergency fund: Put $1000 in a savings account at 4.5% and $500 to the credit card in January, $1500 to the credit card in each of February, March and April, and the remainder of $1091.24 in May.

Total CC interest for plan #1: $63.27 ($62.84 if crushed into 4 months).
Total CC interest for plan #2: $91.24

Plan #2 means you pay $27.97 more in credit card interest, BUT the total savings account interest earned from January to the end of May is $17.75, so:

Net difference between plan #1 and plan #2: $10.22.

So, Anonymous, if it is vitally important that you save yourself the price of a small takeout pizza over the next few months, don't save an emergency fund until your debt is gone, because the math shows a huge $10 difference.

But if you don't already have an emergency fund, and you want to have cash on hand for rent or other emergencies without having to pay for a high-interest advance on your credit card (assuming that you actually have enough left on your credit limit to let you do so and that the credit company doesn't start to reduce it), this first month, pay $1000 to savings and $500 to your credit card, then put everything on your credit card until it's paid off.

I haven't calculated compound interest since Grade 9. What are the odds that even using this calculator, I screwed things up? :-)
posted by maudlin at 10:46 AM on January 6

Maudlin makes all the correct points above about the comparative interest costs of paying off in 4 months vs 6 months, and as I pointed out even taking 13 months costs a total of $300 in interest. Maudlin, the total cost of debt calculator on bankrate is easier to use and compare. Just use decimals for non-year calculations.

The comparative total costs of the loan are:

1 year: $6296.51 total, $525 a month
6 months: $6158.48, $1027 a month
3 months: $6090.22, $2030 a month

None of this takes into consideration the offset of savings account interest, but I contend that's irrelevant.

FAR MORE IMPORTANT than saving $100-200 is the incalculable lifetime's savings realized by building a habit of only buying things that one can afford.

The poster has managed to build up a quantity of debt s/he is capable of paying off in 4-5 months. This means that s/he has either taken some drastic lifestyle measures to be in this position or has managed to spend more than s/he makes despite having $1500 a month in disposable income. Either way, the clear indicator here is that saving enough to eat at McDonalds once a week for the next year shouldn't be the top priority: building life habits should.

And putting one's self in a situation where one might have to rely upon credit cards for emergency expenses is the exact opposite of the lesson that needs to be learned.

Delaying that lesson by even 4 months is a bad one, but even putting that aside it's a better plan to forgo the $200 and focus on the savings. The poster's life situation might be stable now, but next month is unknowable. If s/he suddenly loses his/her job or has some other problem it's possible s/he won't even have the minimum payment amount.

Once that happens we're in big fee territory, and I believe the industry average for late payments is now about $30. I'd also be surprised if, given current economic times, credit card companies aren't much more diligent about cutting off access to more credit once you start missing payments. So this supposed credit card emergency fund is not a robust fund at all. There's also the possibility for $30 a month over-limit charges.

Far better to pay the $300 over the next year and build the foundation to insure that's the last revolving card interest the poster ever pays in his/her lifetime.
posted by phearlez at 2:59 PM on January 6