This question was recently posed on a forum I read. It was from a person who owed $4,000 in credit card debt and was going to get a tax refund for about that amount. She wanted to know which would make the most sense – to save the money or to pay off her debt.
A simple answer
The answer to this question is pretty simple. She should pay off the debt. It’s probably costing her 18% or 20% APR (average percentage rate), which is a lot more than she could earn by tucking the money away in a savings account or even a certificate of deposit.
Pay off debt first
Most financial gurus say that you should always pay off your debts before saving or investing money. One of the reasons is what I wrote above – which is your debt is costing you much more than you can earn if you save the money. The second reason has to do with your credit score. There are five factors that determine your credit score. One of them is called “credit utilization.” This is a ratio determined by the amount of total credit you have available versus the credit you used. If this young woman had total credit available of $5,000 and had used $4,000 worth of it, her credit utilization ratio would be 80%, which is much too high. She could improve her credit score just by paying off that $4,000 credit card debt.
If she would rather save the money
While that $4,000 dollars wouldn’t earn much interest, she might feel better and more financially secure to have the money tucked away in a savings. If this were the case, she could look at some alternative ways to earn money and pay off the credit card debt in a year or less. The obvious and simplest way for her to do this is take on a second job. Assuming she had a standard 40-hour a week job, she could find part-time jobs evenings or weekends to supplement her salary. Or she might be able to take on extra shifts at her present job. Working a second job may not be much fun. But if she were to use all the money she earned to pay off her credit card debt, she could get rid of it in a relatively short amount of time.
The best paid second jobs
The second jobs that pay the best are professional-type jobs. People who can do accounting, legal research, tutor students, teach dance or Pilates can earn really good money and get out of debt fairly quickly. However, if you don’t have those kinds of skills, don’t despair. You could probably find a job in the hospitality of food industry that wouldn’t pay nearly as much but remember that you could use everything you earn to pay off your debts.
Go on a budget
If this woman was unable to take on a second job, she should definitely develop and stay on a budget. This is by far and away the best way to manage personal finances and to pay off debt. It will likely take longer to pay off at $4,000 than if she were to get a second job. But creating and sticking to a budget has long-term benefits beyond just paying off debt. It’s really the only way to realize your short-and long-term goals in life.