Should You Pay Down Debts or Save Your Money?

Here in the UK, we are always being told to save. But many of us are in debt and if you are in debt, saving before paying them off is not likely to be the best financial choice. Banks and financial institutions, without a doubt, love us to have debt and savings with them. But if you want to be better off, then you should pay down debts (possible even including your mortgage) before you save.

Yes, Pay Your Debts Before Saving

This may sound contrary to all the advice we are given to save, save, save. But the simple fact of the matter is that debts usually cost more than savings earn. Cancel them out and you will be better off. For example, if you owe £1,000 on a credit card, paying interest of 18%, the cost of the debt is £180. If you save £1,000, with a typical interest rate of 1.5%, you will learn £15 in interest. That means that if you use that £1,000 in savings to eliminate the debt, you would be £165 a year better off. The maths is simple. Pay your debts before saving.

Do you want to lend banks money so they can lend it back to you at a higher cost?

Unfortunately, if you hold debts and savings with the same financial institution then you are effectively lending the bank your money in the form of your savings, only in order for them to loan it back to you while charging you more for the privilege! The difference between the savings rate and the borrowing rate of a bank is that bank’s profit, and banks need profits, so it only stands to reason that it will always cost more to borrow than you can earn by saving.

Are there exceptions to the rule that you should repay debts before saving?

While it is almost always better for you to pay off debts before saving, there are exceptions. These are:

Where penalties apply for early repayment of a debt.

Some loans and mortgages tie you in, so you have to pay a penalty fee if you pay it off early. If this penalty is higher than the amount you will save by using your savings to pay off the debt, then leave your excess funds in a savings account until the penalty is smaller.

Where the debt is interest-free or very cheap.

If you have an interest free credit card or another free or very cheap debt such as a 0% overdraft then you will be better off if you leave the debt as it stands and start to save. Just be careful about interest free debts rolling over and costing you more once the interest free period has elapsed. Student loans also usually fall into this category – these cheap loans are usually best left as they are as you begin to save your excess funds.

But Shouldn’t I Have an Emergency Fund?

Many of us like to know that we have an emergency fund to fall back on should something bad happen or an unexpected expense arise. It can give us a sense of peace of mind to have a pot of money ready for emergencies. For the debt free, this does, obviously, make sound financial sense. But if you have debts – it may sound screwy, but you would still be better to pay off your debts first before you start saving for that rainy day. Again, this is simply down to the maths of the situation.

Say you have £5,000 saved up, earning 1.5% interest (£75 a year) but also £5,000 of credit card debt, at 18%, which costs £900 a year.

If no emergency arises, overall, you would be paying out £825 a year. But if no emergency arises and you use the savings to pay off the debt, you would be £825 better off, and able to properly begin to save.

If an emergency does arise – say you need the £5,000 for an emergency roof repair – you would be left with no savings and £5,000 of credit card debt would remain. If you had paid off the debt with your emergency fund before the emergency arose, you would have no funds available to pay for the roof fix. You would have to borrow the £5,000 on your credit cards, so ultimately, your situation would be exactly the same – except that before the emergency, you could have been better off had you used the funds to pay off the debt.

The only reason that it might not be size to pay off debts rather than creating an emergency fund is if you have a poor credit rating from the past and so may have trouble getting credit in an emergency.

Should I Pay Down My Mortgage with Savings?

While many people do not think of their mortgage as debt, of course it is a form of debt. Though the interest on a mortgage will usually be lower than on other debts, the maths still shows that you would be better off if you pay down your mortgage rather than saving (unless the early repayment penalty negates the savings to be made on the interest). Paying £10,000 off your mortgage with savings (at typical interest rates) could leave you £350 per year better off. You can usually overpay by 10% of your mortgage balance per year, though check with your mortgage provider to see what overpayment policy applies on your mortgage. If your mortgage has rolled over onto a standard variable rate, you may be able to save more by remortgaging than you can by overpaying.

Which Debts Should I Pay Off First?

If you have other debts with higher interest payments than your mortgage, these should always be paid off first in order to get the best savings. Begin by paying off your most expensive debts, and work down your debts until you are largely debt free before you concentrate on saving.

Even where you cannot pay off all your debts, make sure you have done what you can to make them as low cost as possible. Money Pug can help you source the best credit card deals, loan deals and mortgages or remortgage deals. Once your debts are as cheap as they can be, work to pay them down rather than saving, then, once debt is gone, you can begin to save properly.