At first glance, the question seems preposterous. Why would you ever borrow to pay off an existing debt? Wouldn’t the net result be the same? Actually, borrowing cash to pay off debt is more common than you might think. And that was exactly the question Barbara, a subscriber to my weekly newsletter, asked (you can subscribe by clicking here):
I will be coming into a lot of money.. My question is– should i put it into the bank and borrow against it to pay off all my debts??
As I said, this is a lot more common than you might think. Refinancing your mortgage is borrowing to pay off an existing debt. Using 0% balance transfer credit cards to pay off high interest cards is another example. Student loan refinancing is a third example. The list could go on.
The reader’s question, however, is a bit different. Normally when you refinance, you don’t have the cash to pay off the debt. You’re simply exchanging one debt for another, typically to lower the interest rate. Here, the reader has the cash to erase her debt, but wants to consider other options. The situation raises several questions:
- Why not just pay off the debt?
- If you don’t want to pay off the debt, why get another loan?
- Can the cash help you lower the interest rate on your debt?
Let’s take a look at each question.
Why not just pay off the debt?
There are a lot of reasons not to pay off a debt in one lump sum. Generally, the question is whether you have a better use for your cash. There are many situations where paying down debt may not be your best use:
- Emergency Fund: Liquidity is a big reason not to pay off all of your debt. You need some cash in case of emergencies. Dave Ramsey recommends having at least $1,000 in the bank. I think an amount equal to three months of expenses is a better approach. Whatever you decide, cash on hand should be consider when you decide how to tackle your debt.
- Investing: I’m a big believer that folks should start investing NOW. Unless you’re paying crazy interest rates, I see no problem with investing while you also tackle your debt. It’s not one or the other; there is a balance. And that’s particularly true if your employer matches 401k or 403b contributions.
- Big Purchase: You may be saving for a big purchase like buying a house. If that’s the case, you’ll need cash for the down payment and closing costs.
- Low Rates: If you have really low rates on your debt, it may not make since to pay it off right away. This is certainly the case when you have debt at 0%. It can also be the case when you have really low fixed rates. That’s the case with my wife and I. We have a mortgage at 3.875%. While that’s more than we currently earn from our online savings account, I’m reluctant to pay it down in big chunks. Why? Because we all know that rates will be rising in the foreseeable future. If rates rise above 4%, we’ll be able to make some dough by just keeping cash in a savings account.
If you don’t want to pay off the debt, why get another loan?
If you decide not to pay off the loan immediately with cash, why get another loan? That’s my big question for the reader. As with most personal finance questions, so much dependson specific circumstnaces.
For example, one reason to get a new loan is to consolidate debts. It can be a lot easier to deal with one monthly payment. By consolidating multiple debts into one, you can simplify your finances significantly. Of course, interest rates must always be considered.
And that brings me back to refinancing. If you can lower the rates on your debt after factoring in the costs, than you can save money and get out of debt faster.
Can the cash help you lower the interest rate on your debt?
The reader’s question raises an interesting issue–can you put money in the bank and than borrow against it? As far as I know, this is not a common occurrence. One can certainly put up collateral to secure a loan. We do it all the time with our homes (mortgages and home equity lines of credit) and with our cars.
But I’ve not seen a bank offer a lower rate on a personal loan if you have cash in the bank to secure the debt. You can borrow against securities held with a broker. When you secure a loan with stocks, bonds, and mutual funds in your portfolio, it’s called a margin loan. There are significant risks with margin loans, however, and they seem a bit beyond the reader’s question.
In the final analysis, you have to assess liquidity, interest rates, and convenience (think loan consolidation) to make this decision. As with most personal finance decisions, keep in mind that it’s not all or nothing. You may choose to pay down some of your debt, while holding on to some cash for emergencies or investing.