If you have any loans, you may be wondering whether it makes sense to pay them off. And if so, exactly when should you use savings to pay off loans? It’s a good question. Loans feel like a burden. And it would probably feel great to never have to think of them again.
But the actual answer depends on your particular situation. In general, if your loan rate is higher than the interest you get on savings, you should probably pay them off. That’s because your loans are costing you more than you’re earning. But, as I said, your situation may require a different choice.
When you might NOT want to use savings to pay off loans
There are a few circumstances where you’d be wise to keep paying the loans, even if you have savings. Let’s look at them one at a time.
1. Amount of total savings you have – You don’t want to use savings to pay off loans if you don’t have much savings. Even if you’re paying off an 8% loan and only earning 1% on your savings, you need liquidity. That means ready-to-use cash in the event of an emergency.
When it comes to how much cash you need to keep free, a good rule to go by is at least 6 to 8 months of basic living expenses. And, since emergencies themselves can pull a lot of that spare cash, upping the amount is probably a wise move.
2. Large expenses coming up – You may already know of something coming up in the future that will require a large expenditure. Dental expenses. Major car repairs. A lump sum balloon payment that’s coming due. Education expenses. And anything else needing lots of cash.
If you use savings to pay off loans without enough reserves, you’ll leave yourself short when it comes to emergency situations. And then you’ll be stuck with an even costlier emergency loan!
3. Penalties on selling your investments – If you have your money in CDs or other time-dependent investments, you need to check how much you’d lose. And the same goes for any investments that are at a lower value right now due to market fluctuations.
Also, if you are tapping into your retirement account early (and I suggest you don’t) beware of penalties. And if you are past 59 1/2, remember to factor in any income taxes on your IRA accounts.
4. Retirement accounts in general – Don’t look at retirement accounts as savings to play with. Especially not a source to use savings to pay off loans. Besides the penalties I talked about in the last section, you’re losing the valuable money growth that comes with compounding. Think of these as things to add to — not normal money resources.
A few more thoughts
Now that we’ve covered when not to use savings to pay off loans, let’s return to original idea. For any savings that are free and clear and above your liquid cash reserve limit, if you are able to pay down loans that are costing you more in interest than you are making … go for it!
One more thing besides the cost of the loans that comes into play. Friends of mine had about $55,000 left on their mortgage loan, with only a few more years to go. But they had more than enough savings to safely pay it all off. I suggested they go ahead and just do it. And the feeling of freedom they felt when their bank told them they were free and clear was wonderful to see!
Some financial decisions are about choices that help your money grow as much as possible. And some are about how you feel about the financial obligations you carry. Hopefully you can blend the two. But if it’s a close call, go for what feels best. Peace of mind is truly priceless.
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