Saving money and paying off debt are both crucial to achieve great financial health.
It’s good if you can do both, but if you’re struggling financially, you might be confused about which one you should tackle first.
Here’s an unpopular opinion – pay off the debt with savings!
But doesn’t dipping into savings put you at risk of going back into debt? Well, sometimes it makes sense to pay off the debts before saving.
Keep reading to understand how.
Interest Cost vs Interest Earned
Saving vs paying down debt boils down to calculating the opportunity cost of doing one thing over another.
Check out this scenario. You have a £2,000 debt in a credit card at 15 per cent APR and £2,000 saved up in a savings account at 1 per cent APY.
The interest cost for your debt is £300, while the interest earned on your savings is £20.
As you can see, the debt costs more than what the savings earn. In this case, you’re better off cancelling them out – so long as you have an emergency fund (see more on this below).
Understanding Your Debt
You probably have a variety of debt—most Britons do. Debt in any form can be overwhelming, but some debts are worse than others.
Term loans such as auto loans and revolving credit like credit card debt can affect your financial future differently.
How so? While term loans have a set deadline for repayment, revolving credit continue to roll over until they’re paid off. This makes revolving credit easy to get out of hand.
Annual percentage yield (APY) is what you earn on savings, while annual percentage rate (APR) is what you pay on the consumer debt you owe.
When the interest you earn from savings is more than the interest you pay on debt, it’s logical to pay off debt first.
How to Pay Off Debt
There are three main methods you can use to pay off consumer debt:
- Avalanche Method
The avalanche payment method focuses on the debt with the highest interest, paying it off (while still making minimum payments each month on all other loans), and progressing to the next high-interest rate debt. The idea is to save you more in the long run. - Snowball Method
The snowball method starts with the bulk of payments being directed to your lowest balance first, paying it off, and progressing to the next lowest balance. The idea is that small wins will keep you motivated and reduce the number of payments you make. - Debt Consolidation
Credit card consolidation is another method you can explore. It involves transferring high-interest credit card debt to a new card with a lower APR. The stiff competition between credit card issuers means you can even negotiate your interest rate.
Benefits of Paying Off Debt First
Besides reducing the amount of interest paid overtime, there are other reasons to pay off debt with
savings:
- It can help to improve your credit score.
- Tackling debt can lighten a mental/emotional burden.
- You can focus on saving and other areas once your debt is paid.
Can You Pay Off Debt and Save?
Yes, it’s possible but not the best idea.
Look at it this way. When you put your savings in a bank, you’re actually lending the bank money for it to lend to other customers.
The difference between the savings rate and the borrowing rate is the bank’s profit. This implies that it will always cost more to borrow money than you can earn by saving with the same bank. In other words, your bank is lending you back the money you gave them, except charging you much more.
There are, however, two exceptions: loan lock-ins were paying off a loan early incurs a penalty, and interest-free or cheap debt where the interest rate on your debt is less than the amount your savings earn.
Building an Emergency Fund
Before you start paying off debt with savings, it would help to first focus on building a rainy fund in a separate account.
Without a cushion to fall back on, you could simply end up adding more debt to pay for an unforeseen roof repair or a trip to the car repair shop.
The emergency fund should have 3-6 months’ worth of living expenses.
Conclusion
Carrying debt is a financial burden that can affect your credit score and your peace of mind.
If you have financial goals that will require good credit on the horizon, then it might be wise to focus on paying off your debt first.