The pros and cons of debt reduction vs. emergency fund

Monday, January 14th, 2013 By

weighing the pros and cons of debt reduction vs. savings

A low average return on savings could make debt reduction pay off more, but people can't ignore their emergency fund. Image: Thinkstock

In these uncertain economic times, should a person try saving money or reducing credit card debt? With the average return on savings in the U.S. so low, many financial experts say that consumers will come out ahead in the long run with debt reduction. Basically, the cost of carrying credit card debt outweighs the benefits of saving money. Americans as a whole agree, as consumer credit is experiencing its deepest decline in history. This is good for individuals trying to regain their financial footing. But massive cutbacks in consumer spending are hurting the economy as a whole. The result is an environment that makes saving for an emergency fund in lieu of debt reduction a good idea.

Low interest rates favor debt reduction

Record-low interest rates could mean that debt reduction will pay off bigger for the time being than bolstering an emergency fund. Peak Personal Finance reports that low rates mean cash saved in an emergency fund yield less. It is likely peopleĀ  will benefit more by paying down high interest debt than putting money into a so-called “high yield” savings account. According to Money-Rates.com, the average return on savings accounts under 10,000 as of July 24 was 0.80 percent. Plus, there’s a good chance credit card companies will raise rates significantly when the economy improves. The present environment could be the best time to make meaningful headway with credit card debt reduction.

The debt reduction trend

The flagging economic recovery in the U.S. apparently has consumers following that advice. Financial-Planning.com reports that middle class savings tumbled to an eight-month low in June, according to a report by First Command Financial Behaviors. It was the lowest rate of savings since October 2009. At the same time Americans have stepped up reducing their debt. But the debt consumers paid off wasn’t enough to offset the savings reduction. Those with a positive savings-to-debt ratio, which is total savings compared to total debt, dropped 39 percent in June, down five points from a record-high of 44 percent in the first quarter.

Emergency fund can’t be ignored

Although the numbers dictate that debt reduction may offer more financial benefits that debt reduction right now, Peak said that people still can’t ignore their emergency fund. Everyone should have a monthly savings goal. How much of that cash goes either to debt reduction or savings depends on a person’s situation. If job security is an issue, the emergency fund should get priority. People who feel secure in their jobs could do better by aggressively pursuing credit card debt reduction.

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