I recently received an email question from a reader.  Since it may be relevant to many people, I am answering it in a blog post. The email is as follows (reprinted with permission).

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I have about $13k in credit card debt at 25% interest.I also have $12k in an auto loan at 10%.  My savings account currently has about $25k in it, mostly in a modified permanent portfolio.  

Should I just take that $25k, wipe out my savings and pay off all of my debt? My job is pretty secure at the moment.  If I had an emergency I would always have open credit cards.  And long term I would be able to save more not having to service all of that debt.  Opinion?  Financially it seems that having no debt is the smart thing.  Psychologically however, seeing money in my savings is comforting.  Seeing open credit on a credit card (that could possibly be taken away at any time by the issuer) is not as comforting.

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The question basically boils down to whether it is appropriate to sacrifice an emergency fund to pay down debt.

First, this is a personal scenario.  The details of the question are good, but I can never know everything about a person’s situation.  It isn’t just a math question.  He says it is comforting seeing money in savings, but I don’t know how much discomfort there is in carrying the debt.

I don’t like to tell someone what they should do because everyone’s situation is different with specific details.  And even if you get two people with virtually identical financial situations, they probably have different personalities.

With that said, the big thing that pops out at me is the high interest rates.  The 25% interest rate on the credit card debt is really high.  Even the car loan debt at 10% is high, especially in today’s environment of relatively low interest rates.

I am an advocate of setting up a permanent portfolio, which he follows. But I don’t like the thought of making a 5% return on investment (or something like that), yet paying 25% interest towards debt.

As I like to say, you don’t get rich by paying interest.  You get rich by collecting interest.

If I were in this situation, I would immediately pay off all of the credit card debt with the savings. Again, I can only say what I would do given what I know.

I am assuming that he has access to all of the money and that it isn’t in a retirement account. Therefore, it should be easy to access and get into his bank checking account.  I would pay off the total balance of the credit card debt as soon as possible and stop paying those enormous interest rates.  I would then vow to pay off the total balance every single month until the end of time, barring a major emergency.

The auto loan debt is a little trickier.  It is still a high interest rate, but I wouldn’t want to go down to zero savings. I have no idea what the monthly payments are, but I am guessing the principal balance is going down by $300 per month or so if it is somewhat typical.  Therefore, in another three months, the auto loan may be down to $9,000.

I don’t know how much he saves each month.  If it is zero, he needs to find a way to change that.  He needs positive cash flow, even if it is a couple of hundred dollars per month.

I would leave at least a month’s worth of expenses in savings.  Beyond that, he could pay down the auto loan at this time without completely paying it off, but it isn’t quite as clear to me with this.  If he has a decent savings rate and he feels rather secure in his job, then he could pay the whole thing off.

It does make a difference regarding someone’s personal situation.  If you are supporting a family and own a house, it is probably good to have some money in reserve.  If you are single and renting an apartment, you are less likely to have emergency expenses.  Then it comes down more to the math, which says to pay off the high interest debt.

As was said in the email, he can always access the credit card again in case of an emergency. But I would want it to be a very serious emergency to go back into credit card debt.  I doubt that the credit card companies are going to shut down the card or cards, assuming there are no stolen cards or identity thefts. Even with a stolen card, you should get a new one in less than a week.

In summary, if I were in this situation, I would immediately pay off the entire balance of the credit card debt.  I would think about paying down the auto loan while maybe keeping a month’s worth of expenses in the bank.

I like the permanent portfolio, but not at the expense of paying 25% and 10% interest rates on debt.

Once the debt is gone, then your savings rate should go up.  That is with anything.  If you pay off a home mortgage, then your cash flow should increase each month by that amount (the principal and interest).  In this situation, the money that would have gone to credit card payments and auto loan payments each month can be put back into savings.

Without any credit card debt and car loan debt, then it should be easier to save and build up that emergency fund.  Then the permanent portfolio becomes a good option.