Americans are certainly familiar with credit card debt. The average household that's carrying a balance on their plastic owes about $16,000 on the cards alone. The problem, of course, is that the more debt you have, the more money you end up wasting on interest charges -- charges that can compound on a daily basis. It's for this reason that you might rush to pay off credit card debt before beginning to tackle any of your other financial goals. And generally speaking, that's a good idea -- as long as you put a decent savings cushion in place first.
Your emergency fund takes precedence
Many of us cut back on expenses or work side jobs to generate cash that can be applied to our credit card balances. But even though racking up interest charges only slows you down on your path out of debt, if you don't have an emergency fund, building one should be your absolute first priority.
The reason? You never know when you might fall ill, lose your job, or encounter a major unplanned expense. In such a scenario, without an emergency fund, you'll be forced to -- you guessed it -- take on even more debt. And that assumes you even have the option to borrow your way out of a jam. If you're already near or at your credit limits and come to need money, you can't exactly whip out your credit cards and bail yourself out. Rather, the only way to protect yourself is via an emergency account, and ideally, yours should have enough cash to pay for three to six months' worth of living expenses. If you're nowhere close to that, focus on building some savings before you tackle your mountain of debt.
When to pay off your credit card debt before anything else
Some people will tell you to save for retirement before paying down your credit cards. But once you have that emergency account fully funded, the first thing you should do with the cash you're not immediately using is apply it to your outstanding high-interest debts.
Though setting money aside for retirement is crucial, if you invest wisely, you'll probably earn somewhere in the ballpark of a 9% yearly return, because that's what the stock market has averaged historically. Now, a 9% annual return is hardly something you want to give up, but consider what your credit card company is charging on your balance: It could be 20% interest or more every year. If you're wasting more money on interest than you're likely to profit from investing, paying those cards off first becomes a no-brainer. (One caveat: If you have access to a 401(k) with an employer match, contribute enough to get the maximum match you can -- that's free money.)
You should also pay off credit card debt before saving for other milestones, like buying a house or a car. Since homes and vehicles typically require financing of their own, it makes sense to retire your old debt before taking on more new debt, even if it is the sort generally viewed as the good kind.
Also keep in mind that paying off your debt can improve your credit score by lowering your credit utilization ratio, which measures the extent to which you're using your available credit. A lower credit utilization ratio will generally boost your FICO score, and the higher your score, the better the interest rate you'll qualify for on mortgages and other loans. So, say your total available credit is $10,000, and you owe $6,000 on your various credit cards. You are using 60% of what you can use: That's your utilization ratio -- and it's high. Pay off $3,000 of that balance, and your ratio drops to 30% -- a number in the neighborhood that the credit bureaus prefer, and for which they will likely reward you.
Credit card debt is not only costly, it can also damage your credit. If you have money available to pay off your balances, do it -- as long as your emergency fund is in good shape. That way, you'll avoid losing more money to interest, and you'll be able to move forward with a clean financial slate.
The Motley Fool has a disclosure policy.