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Financial priorities during a job transition: Save money or pay off debt?

by Steve Holder

Created on: May 23, 2008   Last Updated: June 10, 2008

If you've ever followed the business news, one of the things you may have observed is that during financially stressful times, large companies hoard cash. Why? Because it's the smart thing to do. In times of slow economic activity, cash is king. This applies not only to corporate finance but also to personal finance.

After suffering an unexpected job loss, one of the most critical and most immediate steps necessary for survival is to stop cash leaks. Cash on hand enables us to weather the storm. And the more cash on hand, the longer the storm we can survive without succumbing to a cash flow crisis.

So when it comes to choosing between saving money or paying off debts, the answer depends on which gives you the longest survival time. In most cases, using cash to reduce debt shortens survival time. Let's take Howard's case as an example.

Howard had a decent job and a beautiful family. They were not rich by any means, but they were able to put a little money aside for retirement and their two sons' future college expenses. They had a typical mortgage, car payments, credit card debt, and a small bank loan they had taken out to re-roof their house a few years back.

When Howard is laid off suddenly, he's initially in shock. But being a practical sort, he processes his anger and denial quickly and starts formulating a survival plan. He starts by making several lists.

Monthly expenses
Expected income from unemployment insurance and possible freelance work
Savings, IRAs, and assets easily converted to cash
Outstanding balances on debt

Comparing potential income to current expenses, Howard not surprisingly finds himself with a negative cash flow. Using savings and borrowing against his IRA, he calculates he can cover the negative cash flow for three months.

Looking very carefully at his expenditures, he determines that by cutting or reducing some discretionary spending, he can stretch his available cash to cover four months of expenses. He breathes a sigh of relief thinking that getting another job within four months should be entirely doable.

Next, Howard examines his debt payments and balances to see where he can stretch his survival time further.

Obviously, paying off his mortgage is impossible. The balance on his car is about equal to his entire cash resources. Paying that off would deplete him completely and reduce his survival time to about a week.

The bank loan for the new roof, however, has only four payments remaining until it is paid off. Paying the balance off now

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