Is it better to save or pay off debt?
As a general rule, it’s better to pay off debt before putting money into a savings account. This is because, in most cases, the interest rate you’re paying on debts such as credit cards and loans will be higher than the interest rate you’re earning on your savings.
ExampleLet’s say that you have the following:
A credit card that charges 20.9% in interest
A personal loan that charges 7% in interest
A savings account that earns 4% in interest
In this scenario, borrowing costs more than you earn by saving, so it makes better financial sense to prioritise paying off your debts over increasing your savings.
In essence, if your loan and your savings account are with the same bank, the bank is effectively letting you borrow money you’ve already lent to the bank, but it charges you a higher interest rate than it is paying.
Should you always repay your debts before saving?
As with most things in life, there are some exceptions to the above rule.
Exception 1: If there is an early repayment fee for paying off your borrowing ahead of schedule. For example, many loans and mortgages come with set repayment plans – if you alter this by paying off the debt early, the lender may charge you. In this case, it may be better to continue with your repayment plan and focus on building up your savings instead.
Exception 2: If the interest rate on your debt is lower than the rate you are earning on your savings. This might be the case if you’ve got a 0% credit card that charges no interest for a year or so. In this situation, as long as you can clear your balance before the 0% deal ends and interest kicks in, it can make sense to take advantage of this cheap borrowing and start saving instead.
Exception 3: Student loan borrowers. Because the amount you repay on a student loan is linked to your earnings, many people never repay their loans in full. Therefore, for those people, it’s not worth prioritising student loan debt over saving.
Should you overpay on existing debts, like a mortgage?
Your mortgage is likely to be the biggest debt you’ll ever have, and it is often taken out over a term of 25 to 30 years. Therefore, making overpayments to pay off your mortgage early can make good financial sense. However, it’s important to consider your personal circ*mstances first.
Many mortgage lenders will let you overpay by around 10% of your remaining mortgage balance each year, penalty-free. This can help you pay off your mortgage faster, and you could save thousands of pounds in interest, too.
However, overpaying on your mortgage won’t necessarily be the right choice if it means sacrificing other lifestyle choices, such as going on holiday or saving for your children to help them get on the property ladder or pay for their education.
So you’ll need to consider what works best for you. You might, for example, want to focus on paying into a savings account but also overpay on your mortgage from time to time if you have enough spare cash.
Should you have an emergency fund?
Experts generally recommend that you have at least three to six months’ worth of expenses in a savings account that you can draw on in an emergency. This could help you keep up with your rent or mortgage repayments if you were made redundant or pay for a new boiler if yours breaks down.
It’s a good idea to keep these funds in an instant-access savings account so that you can access the cash quickly. Look for an account with a high interest rate and check how much you need to open the account initially.
However, other experts argue that if you have emergency savings, it’s better to use them to pay off costly, shorter-term debts, such as your credit card or overdraft, and then start building a new savings pot. Keep your credit card account or overdraft open so that you have it ready if you need to cover an emergency expense.
This will not be the right option for everyone, though, and you might feel uncomfortable without a savings cushion.
Why should you repay your debts?
Paying off your debts shows you’re a responsible borrower and your credit score should go up as a result. The quicker you get out of debt, the less interest you will pay and the more cash you’ll have to put towards your savings.
Crucially, however, if you don’t pay off your debts, there can be serious consequences. If you fail to repay your mortgage, your lender could ultimately repossess and sell your home to recoup its money.
For other debts, your lender could start debt collection proceedings or take court action against you if you don’t repay what you owe.
If you’re struggling to meet your repayments, contact your lender as soon as possible. They should work with you to develop a new repayment plan that will make your credit agreement more affordable.
