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Steve Bucci, the Bankrate.com Debt AdviserGot a raise? Start an emergency fund

Dear Debt Adviser,
I recently received a modest increase in my salary and want to use the amount remaining after taxes and a 401(k)-percentage contribution to pay down debt. Should I use these funds to pay down a substantial credit card balance with a moderate interest rate, or should I add principal payments to my fixed, low-interest mortgage loan, which has 26 years left on it to pay? Thanks.
-- Linda

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Dear Linda,
Congratulations on the raise, and what a smart, sensible person you are!

I guess the knee-jerk reaction to your question would be to recommend that you pay down your credit card debt first, if only because you have a "moderate" interest rate on the credit cards as opposed to a "low" interest rate on your mortgage loan. There is also the fact that your mortgage interest might be tax-deductible whereas your credit card interest is not. You could split it and use half of the raise on each debt. From a purely dollars-and-cents standpoint, paying down high-interest debt first gets you out of debt the fastest. But both ideas have merit and would benefit you.

However, there are two other options you might consider.

I see that you are a regular contributor to your company 401(k) plan. But do you also have an emergency savings account in place? If not, this is an excellent time to start one using a portion of your new raise to get started. You might use half to put toward your credit card debt and put the rest in a savings account to use for emergencies.

Although your contribution to an emergency fund might be small to start, if you have read my column very often, you know that I believe an emergency savings account is one of the best ways to stay out of debt trouble. I also advocate saving "new" money, such as raises and bonuses, which is what you would be doing here. Saving at least half of new money is fairly painless, since you never get used to having the extra amount at your immediate disposal.

While getting out of debt as soon as you can is important, getting into the habit of saving might be more so for your future. An emergency savings account will be there when your car breaks down or your washing machine dies. These life events are bound to happen one way or another, but having that savings will certainly cushion your financial life. Six months' living expenses is what you should shoot for in a readily accessible, liquid account.

If I'm preaching to the choir and you already have adequate emergency savings, double kudos to you on your sensible nature. My last thought is to consider the relative value of paying down your mortgage versus adding to your long-term investment account. You are on the right track to becoming debt free. Other people would do well to follow your example.

Good luck!

The Debt Adviser, Steve Bucci, is the president of Money Management International Financial Education Foundation and the author of Credit Repair Kit for Dummies. Visit MMI for additional debt advice or to ask a question of the Debt Adviser go to the "Ask the Experts", page to ask a debt question.

Bankrate.com's corrections policy -- Posted: May 12, 2006
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