Tuesday, June 28, 2011

Is it better to save or repay debt?

Most financial advisers agree that it's a good idea to have at least three months' salary set aside, ready for a rainy day. Judging by recent headlines, though, many people are finding it really difficult at the moment to put money into savings.  

'Only a third of people saving for their pension'. 'People cutting back on spending to repay debt'. 'One in three households saved less over the last month'. These are the kind of headlines we see so often when we read the news these days. 
[Soft Break]Families all over the country are making difficult choices every day. Generally, it's better to pay off debt first before saving - but not in all circumstances.  
[Soft Break]The 'better off' argument 

Imagine your savings account has a 3% interest rate and your credit card charges 17% APR. 

If you put £500 into that account, you will earn around £15 in interest over one year. In the same period, £500 of debt on that credit card would cost around £85 in interest. (Note that this is a simplified example that doesn't take into account the effects of repayments over that time.) 

Put simply, that credit card would cost you more over one year than you could earn in interest on money in that savings account. So you would be financially better off if you were to repay your credit card first. 

Repaying a mortgage or loan early 

If your mortgage tracks the base rate, it's likely you're paying a low interest rate at the moment. You could take that opportunity to 'overpay' your mortgage while it's less expensive. By the time interest rates rise, you will have reduced the amount you owe by more than if you had just made your regular payments every month.  

However, if your mortgage - or any other debt - charges fees for early repayment, repaying early could work out to be the more expensive option. 

Consider the consequences 

There are strong arguments for saving - savings can deliver peace of mind and act as a safety net. Imagine a sudden drop in income or unexpected expense - without savings, you might well have to borrow.  

However, repaying your debt more rapidly than you actually have to can also make a lot of sense. Repaying a debt more quickly can drastically reduce the amount of interest you pay in total. Just make sure you make all the payments you actually must make in a month before you think about overpaying any of your debts. 

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blueviolet said...

I firmly believe in paying back debt as a priority over saving. It makes the most financial sense in the long run. I've been debt-free for about 4 years now and I will never, ever, ever go back.

Angie said...

We are debt payers also. We did an "emergency fund" of $1,000 first - then pay off all debt (not mortgage) and then save for the 3 months.