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Debt Reduction: Penny Wise and Pound Foolish

Written by Nickel - 19 Comments

Today I’m going to start off by asking a couple of questions…

Are you carrying any high interest debt?

Do you have any money in the bank?

If you answered yes to both of these questions, then let me ask another one…

Just how much money do you have in the bank?

The reason I ask is that a surprising number of people are holding excess cash in the bank while paying ridiculous interest rates and failing to get out of debt.

Sure, you need an emergency fund — and you might want one that’s somewhat larger one than normal given the current economy — but you’re making a mistake if you’re sitting on more cash than you really need.

On the one hand, this is a good problem to have. After all, there are tons of people out there who are in debt up to their eyeballs and have nothing to fall back on. On the other hand, if you’re sitting on more cash than you truly need, then you’re paying a ton of unnecessary interest while earning a pittance from your bank.

My advice: If you think I might be talking about you, sit down and carefully consider how much money you really need to have sitting in the bank. $1000? Six months of expenses? Twelve months of expenses? The “right” answer will vary. But if you’ve got more than that amount stashed away, use the excess to attack your debt.

Published on September 4th, 2009
Modified on March 30th, 2011 - 19 Comments
Filed under: Debt Reduction

About the author: is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

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19 Responses to “Debt Reduction: Penny Wise and Pound Foolish”

  1. 1
    Shogun @ Financial Samurai Says:

    It’s really all accounting guys. My co-writer has about $500,000 cash in the bank, that throws off $22,000/yr in interest income. He also has probably an equal amount of that in rental mortgage and school loan debt, but that debt cost is about the same.

    Right now, “cash is king.” So don’t go using up all your cash to eradicate debt b/c what if you get eradicated one day by your employer?

    Shogun

  2. 2
    LOL Says:

    Nickel: My only debt is my 15-year mortgage. I have 6-months worth of cash in the bank. My only investments are my Roth-401k up to the company match.

    Took me a few years to go here. I think 6-months of cash is about right for my family — I’m about to start throwing my extra cash-flow towards paying off the mortgage early.

  3. 3
    Nickel Says:

    Shogun: That’s a 4.4% return. I’m assuming that they’re doing a lot more than just stashing the money in a savings account — perhaps they bought longer-term CDs a year or more ago? Also, mortgage and school loan debt aren’t exactly high interest. I’m talking here about people carrying high interest credit card debt (@ 15-20% or more) while at the same time sitting on more cash than they really need. Believe it or not, I really do get e-mails from people in this sort of situation.

  4. 4
    Neal@Wealth Pilgrim Says:

    This is a timely piece. It’s also important to consider how much liquidity is enough even if you have no debt.

    My experience tells me that many people are less concerned about being too liquid right after the market has soaked them. They are more concerned about this when the market is hot.

    In reality, we should all reverse the order – a tall order but financially sound.

  5. 5
    Penny Says:

    I have been wondering about this lately. We are young, and our only debt is a fixed mortgage. Do we dump our excess cash slowly into the fixed mortgage, quickly into the mortgage, or stash-and-save for a larger goal (in this case, buying up a little cabin someday when the stash is significant)? This is above and beyond the “emergency fund” amount, of course :)

    So far, I’ve been putting extra towards the mortgage monthly and saving the rest

    I have no retirement investments—just an online savings account—very conservative (read: afraid) of that stuff!

  6. 6
    Greg Says:

    Sorry to twist the subject but what about when all the high interest debt is gone?
    Dave Ramsey likes focusing on paying off your mortgage. I just can’t bring myself to do that. Even with the bleak market I can’t help but believe that with a low fixed interest rate on the mortgage that my money is better off long-term in the market.
    What do you think Nickel?

  7. 7
    Shogun @ Financial Samurai Says:

    Hi Nickel,

    Yes, he’s got several laddered 5 year CD’s between 4% to 6%, and so do I. Citibank today is offering a 5 year, 4% CD too btw.

    I guess I may not be the target demographic to answer this question b/c I’m completely just living off my interest income. I do believe it is absolutely RIDICULOUS someone could keep a 10%+ oustanding CC debt if the savings rate is 4% or less.

    Frankly, are there people who keep an expensive outstanding balance and have a lot of cash? I don’t know…. and I don’t think there are very many if there are, b/c that would be so irrational.

    But, if there are, it’s best to come up with a 12 month plan to slay that debt, while not using up all your buffer.

    Shogun

  8. 8
    Nickel Says:

    Shogun: “A lot” is relative. When you’re paying 15% interest, any extra money sitting around earning 2% is a *bad* thing. And yes, there are people doing this. Irrational, yes, but I get why they’re doing it. It’s comforting to see a decent chunk of money sitting in the bank even if it’s not technically yours.

    Also, FYI: Citi’s 5 yr rate is currently 3.5% APY.

  9. 9
    Nickel Says:

    Greg: Excellent question. I’ve written about paying off your mortgage early a couple of times, and there have been some great discussions.

    Click here for a Google site search for relevant articles: link

    The bottom line for us is that we’re sorta playing both sides. We’re investing aggressively (above and beyond our retirement accounts), but also paying something extra toward our mortgage every month.

  10. 10
    LOL Says:

    I doubt many people are sitting on a huge pile of cash, while at the same time having large amount of credit card debt.

    But, I’d bet that people are sitting on large investments (stocks, IRAs, 401ks), while at the same time having large amounts of credit card debt.

    If you were debt free, would you max out your credit cards to invest in the stock market? If not, then sell the stock and pay off the debt! I wonder how much ‘leverage’ is priced into the stock market because of people doing this…

  11. 11
    Shogun @ Financial Samurai Says:

    Nickel – Guess Citigroup is up to their usual ways and carving up their product offerings. I just deposited some cash today, and they still have the 4% 5 yr CD sign up.

    The real question is what you do between your cash pile and your low interest loans.

    The answer is obvious regarding paying off 10%+ debt as fast as possible.

    Have a good weekend!

  12. 12
    RB @ Financial Samurai Says:

    Hey Nickel – I’m sending a shout out to you and this post next week. Hope you enjoy the read.

    RB

  13. 13
    nancy Says:

    Great topic..yes, I am sitting on some cash, but not enough to pay off my debt. My reasons for not paying off my huge debt, is due to family issues. I am keeping it there sitting (sadly) until the “storms” pass.

    It is killing me not to pay down this debt. Sorry not to give details. Jut writing this out was healing for me.. : )

  14. 14
    basicmoneytips Says:

    I think there are different ways to look at this. I periodically buy stuff and put it on a low interest credit card, knowing that I will pay it off when I get a bonus or options maturing. I have more than 6 months living expenses and it is in various securities that I am just not ready to sell.

    The important point is to watch your interest rates. As your article mentions – don’t sit there and pay riduculas interest rates. Also, watch your debt to equity ratio. Secured debt, such as home mortgages, is not bad.

    Its just a numbers game….

  15. 15
    Lee Says:

    Oh what a lovely query – and one I wish I was troubled with at the moment. Currently I’m still in the ‘get out of debt’ phase of my monetary journey so this isn’t a question that I am personally pondering for a while yet.

    However, as your rightly say given the current climate, I think at least 6 months living expenses is a sensible target. The chances of remaining unemployed (completely) beyond that is hopefully minimal.

    I’ve paid off my highest debt (16.9% credit card), and I’m now working on my 8% loan. The remaining credit card is 0% so I’m just paying off the debt divided by the interest free period on that.

    One of these days soon, I hope to face this part of my journey. :)

  16. 16
    Dan Says:

    Nickel,

    Like the premise on the article, but a suggestion for improvement — throw some real numbers out there for talking points. What’s “high”? Pick a number and talk about why it’s high.

  17. 17
    Mike Says:

    This is a great post with some really good commentary from readers. I like the suggestion of making the article more specific using exact #’s because what exactly is “too much cash?” I am a CPA by trade and am obsessed with personal finance in my free time. However, this is a very difficult question to answer and one that must be analyzed on a case-by-case basis per individual. Especially during the past 12 months where many employers are laying workers off and not many companies are hiring, that emergency fund that was 3 months may need to be 8 months. Keep up the good work, Nickel. By the way, I cam to this site via http://www.mainstreet.com an affiliate of http://www.thestreet.com – good work on the Advertising!

  18. 18
    FinanciallySmart Says:

    I believe that persons should pay off their debt if they have the excess of money inside the bank. Once this is eliminate then they can start rebuilding that account as a debt free person. A financial free life is better than a debt burden one.

  19. 19
    Drowninghere Says:

    I have about $4,400 in an IRA, making .35% interest. I have about $20,000 in credit card debt, which I have worked out a budget for and am chipping away at slowly, but methodically. I have about $7,200 on one credit card that I am paying 16.9% interest on. Due to the economy, my income has dropped pretty sharply, so I have been currently making only minimum payments on all cards but one, trying to get rid of that one and move on to the next using the snowball effect. Would it be wise to cash out the IRA, take the tax hit and use that money towards the highest interest card? Once my credit card debt is gone, I will have plenty of cash flow to start saving more aggressively. I should mention that I am self-employed, so don’t have to worry about being laid off, just worry about a slow market. I am usually very good about my credit card debt, but unfortunately, again because of the economy, I had no other choice but to put some necessary expenses on the credit cards. These are not buying a new wardrobe and going out to dinner charges!!

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