Ask the Piggy Bank: Credit Card v. CD
January 2, 2009 by Miranda Marquit
Filed under Finance
It’s the first reader question of the New Year:
I have a credit card with a $6700.00 balance,with an interest rate of 14%, have a CD which I can cash in to pay this down, CD will yield about $5600.00. Should I use the CD to pay down the credit card? CD is paying about 3.6%
Personally, I am inclined to take the money in the CD and pay down the credit card. The 14% interest that you pay on the credit card more than cancels out the 3.6% you are getting on the CD. Indeed, you will be paying a great deal more in interest than you could earn on the CD. Savings rates are dropping rapidly in a variety of categories, including high yield savings accounts and CDs. It’s what happens as the Fed rate heads lower. In this climate, it might be best to pay down debt while you can, doing your best to free yourself from obligations. Get the credit card paid off, and then start rebuilding your savings.
My only concern is whether or not the CD has reached full maturity. You may have to pay a penalty for cashing the CD in early if the entire term of the CD has not run its course. Do a cost-benefit analysis. Even with the penalty, you may still be saving more by getting rid of the interest payments on the credit card.
Readers: Do you agree with my assessment? Would you pay off the credit card or keep the CD?
The difference in interest expense vs. interest earnings is too great to ignore. The actions taken should depend on what other savings the reader has available. If the CD represents the only accumulated savings, then I would be hesitant to recommend using it to pay off the credit card balance. If not, then by all means they should go ahead and cash out the CD and get rid of a majority of that debt obligation. Even if there is a penalty for closing out early, it will more than be made up for by the interest savings.
Normally, I am a proponent of continued savings regardless of economic condition, but in this case it makes too much sense for the reader to re-apply some or all of that cd to eliminating the high credit card balance at a high corresponding rate. Of course a more accurate course of action could be designed with more information, which could lead to an alternate method and possible preserve the cd, but you can only work with that you are given.
You make a very good point. More information is always good. And I agree that the reader should consider the whole picture before making a decision. But, as you said, with the information given, it appears that it would be best to eliminate some of the monthly expense of paying the interest.
A major unintended consequence of low interest rates. It financially makes more sense to spend rather than save, because there is no incentive to save money right now.
You are right, Jared. And, of course, that is the plan that the government is using to attempt to stimulate the economy: Encourage us to spend! However, spending to get out of debt (and hopefully stay there) is better than most other spending that could be done ;)
@ Miranda:
That is the one reason I do not like it when people ask for help on blogs and forums. They do not have the level of trust to divulge all of the pertinent information, and they are receiving advice from anonymous people who may have no business dispensing such advice in the first place. There is just way too much information that would be required and the informality is not conducive to providing accurate responses.
@ Jared:
There is always an incentive to save, but it may not come in the form of interest income. The ability to lead a financially independent retirement is one such example. By saving for your own future you become less dependent on the government and social security. The incentive to save is a psychological issue each person has to deal with. For some people just knowing that the money is going into their own account rather than to a creditor or retailer is enough of an incentive, regardless of the interest rate.
I would never cash out a CD until it would fully pay off the credit card.
If someone just uses a CD to pay down a credit card there is no telling if they’ll just go put more on the credit card once it’s paid down. At least there is a CD hanging out there for retirement that wouldn’t be otherwise if this person is a spender at heart.
The best option (not knowing the question-asker at all) would be to pay down the credit card on your own to make sure you really know how to be frugal and keep your spending under control, and then when it is low enough that the CD (minus penalties or taxes or whatever) will pay it off in full….then cash it out.
Doing so beforehand might just be a game of financial russian roulette.
We’re getting warmed up now! Eric makes an excellent point. It is important to be careful of where we get our information. Is it credible? Also, as he points out, we should be careful since none of the particulars are known.
Jenny also has a valid point. What happens when the debt is paid down? Will the reader changes his/her habits? Or will it just start the cycle anew? To truly be financially free and debt free, it is important to change one’s habits — and the way one views money.
@ Jenny:
If you assume that the person will just put more back on the card after paying it down, wouldn’t the logical line of reasoning lead one to to believe that the same person will follow the same path even if the card is paid off entirely? In that case, there isn’t much sense in using the CD at all then, regardless of the timing.
(an aside: the longer the cd has until maturity, the better it is to cash it out and apply the money to the credit card balance. The credit card interest in relation to the interest on the CD is so great that the CD will never be able to cover the entire amount of the debt. The interest penalty incurred by cashing out the CD pales in comparison to the interest that will be charged, and compounded on the outstanding credit card balance, especially considering the fact that the credit card has a higher balance associated with the higher interest rate.)
I’d pay down the debt. Besides the interest rate, you also free up money on your budget. Instead of the $150/month payments, you can put that towards savings.
I like your point, Green Panda! Once you are free of the credit card payment, you can more easily start rebuilding your savings — with money that will yield returns rather than suck you dry.
I would use the CD to pay down the debt immediately. Once it is completely paid off you can work towards saving emergency funds, and 3-6 months of expenses. When you get rid of debt not only does it free you up to save more, but you’ll be amazed at how fast you can save!
Thanks for chiming in, Pete. I like the idea of paying down the debt and then saving up. Paying interest is one of the worst things you can do for your personal finances. If you can get rid of interest payments, you are already in a better place.
I’m going to have to agree with Pete. You need to pay off that debt as fast as possible – especially if you’re sporting 20% interest rates.
However, in some cases, debt isn’t so bad, but credit card debt has to go!
I disagree with both approaches. Assuming at least a decent credit history the person is probably getting offers for 0% balance transfers for 12 months or 1-2.99% offers for the life of the loan.
So what I would do is find a good offer, transfer the balance to one option or the other depending, keep the CD, run on cash and make payments as large as possible given other needs.
I carry debt on several cards from an emergency years ago that I am slowly paying off. None is above 4.99%. that didn’t happen by accident.
As mentioned above we really don’t have enough info. Did the CD mature? What is the penalty if it didn’t?
Generally I’d say to pay down the debt. The interest on the credit card far outweighs the interest on the CD. But as mentioned it still comes down to the person’s attitude. They have to want to really get out of debt and not just reduce the credit card for now!
Thanks Success, Miki and FFB! I agree that getting out of debt as quickly as possible is important. But I also like Miki’s point. A balance transfer might be an option. Unfortunately, those kinds of deals are fewer and farther between in the current climate.
Not only are such deals going to become more rare, but a scheme like that is only good if you have the discipline to pay on time and make sure the balance is paid off on time or else the entire deferred interest charged will be applied. Not only that, but even one missed payment and the whole effort is moot.
Ah, that pesky discipline thing again ;)
Lot’s of great comments here. It would be helpful to know more about the reader’s circumstances and if they already have a savings or emergency account. I would hope they do and that CD money wouldn’t be needed for anything else. 14% interest is considerably higher than the cd interest rate. Makes sense to pay down the CC and stop using them for future purchases.
I agree, Passive Dad. A little more info would be quite helpful. I agree that it is a good idea to weigh whether or not the CD money is needed for other things. I assume that it isn’t, since the reader seems to be deciding between paying down debt and just letting it sit.
Sorry Miranda, I just had to bring up the dreaded “D” word!
In this case, cashing out the CD to solve the credit card debts makes financial sense but it doesn’t go to the root of the problem, which is, why is there a balance on the credit card in the first place?
The CD becomes an easy way out instead of considering options like planning a budget, cutting down on expenses and generally living within your means.
I think keeping the debt, paying the high interest and whittling it down monthly may be a better financial education in the long term.
@Jeflin You make a good point that the root of the problem needs to be addressed. If the credit card is paid off immediately, will a lesson be learned? Since the CD does not cover the entire amount of the credit card debt, the remainder could be whittled. Hopefully, the reader, and the rest of us, are attempting to avoid piling up more debt.
It is important to make sure that you pay down your credit car first and foremost. I know you’ve had several other people confirming this as well, but it is really important to get this debt off your hands, especially at 14%! Wow! That is quite a bit. Do you think you would be able to get a different credit card? That might be another option, even though I know credit card companies aren’t giving out many cards or lines of credit right now.
Whatever you do, Good Luck!
In the list of Debts To Be Paid Off, I agree with Jerry that credit card debt should be paid down first. Only payday loans and car title loans should be paid off before credit card debt.
Yes, but you said nothing about payday loans or car title loans. haha!
Car title loans are secured loans. The difference between car title loans and payday loans are that you don’t lose your car if you are unable to pay it back. By the way only a very small percentage of people that get a payday loan are unable to pay it off. Unfortunately horror stories always plague the payday loan industry. There are always horror stories with other loans as well though (AKA Mortgages, especially recently)
Makes much more sense to me to have a payday loan, though than an actual car title loan.
I’m sorry to be so far off topic!
:D I think the point I wanted to make was that car title and payday loans “count” more against you on your credit report and your credit score. I agree that a payday loan is better, since it doesn’t result in your car being taken.