We’re constantly being told that we don’t have enough savings and that we’re too much in debt. The problem is that we can’t both repay debts and build up savings at the same time. Choosing which is best for our finances depends on the interest rates on our savings and debts. In most cases it’s best to repay debts first, but occasionally such as with student loans it makes more sense to save than repay.
Everything comes down to interest rates. The ways banks traditionally made money was by paying a lower interest rate to their savers than they charged their borrowers. If someone was borrowing from the bank at the same time as they had debts to the bank, they were effectively giving the bank money for free.
Borrowers today still typically pay interest rates often several times what they can get in savings. Always pay off debts if the interest on the debt is higher than you can get in savings. If you’ve got £100 in savings earning 3% interest a year you’ll make just £3 over the year, while if you’ve got a debt such as a credit card balance of £100 with a 23% interest rate you’ll pay £23 in interest over the year. It makes much more sense to pay off the credit card debt than to keep the £100 in the bank.
Traditionally it was thought a good idea to having an amount of savings for emergencies. In many ways this is still the case, but credit can also be used in these situations. The more debt you clear, the more credit is available should you fall on hard times. So even when thinking about worst case scenarios, clearing debts is still the best option.
There are however a few instances where it’s better to save than to pay off debt. These fall into two categories: debt that you can only pay off with a penalty, and debt that has really low interest rates.
Some debt has penalties attached to paying it off before the due date. Many mortgages for instance will impose high fees for paying off the debt early, or won’t allow you to pay off the mortgage early unless you can pay the entire amount remaining. In these cases it’s often, but not always, better to save rather than pay off early – unless you have the money to pay off the entire debt at once.
Other debt has very low interest or is interest free. For instance credit card transfer debt might be interest free for eighteen months. If you’ve got no other debt it is best to put your money into a savings account and pay off the debt only when the interest free period is about to end. This requires some discipline not to spend the savings though.
Student loan debt, for loans taking out from the UK government, is typically at low rates. You’ll typically be able to find savings products such as Cash ISAs that offer higher interest than you’re paying out on your student loan. In this case it’s best to put the money into the savings product rather than paying off the debt. Remember to keep an eye on changing interest rates though, and if you’re no longer able to find savings that beat the interest being charged you should instead pay off as much as your student loans as possible.
When considering this don’t forget that if you have a mortgage, it is also a debt – even if the interest rate is comparatively low compared with other financial products. If you’ve got £5000 in savings which you’re earning 3% on, but your mortgage is costing you 6%, you’re paying out £300 in interest while earning just £150. As long as the penalty for making an early repayment is less than the difference, in this case £150, then it’s better to pay off the mortgage than to have savings while you still owe money to the bank.