A lot of personal finance blogs (including ours) talk about the importance of building up an emergency fund and having financial security. However, if you have outstanding debt, you may be wondering, is it better to use your extra cash to pay that off first, or put it straight into savings?
There are obvious benefits to building up savings, but we know it’s also good to pay debt off (especially if your debt is being charged high-interest rates!). So which should come first?
Benefits of paying off your debt first
The main thing to think about - what interest rate are you being charged on your debt and is it likely to increase? When interest rates are on the up, any debt that isn’t on a fixed rate should probably be paid off sooner rather than later!
Benefits of building up savings first
There’s no feeling quite like the security of having a pot of money saved up, right? It’s there to protect you from any unplanned expenses - anything from unexpected car repairs to spontaneous nights out with your mates (we said unplanned, but we didn’t say it had to be essential). Having savings gives you the freedom to live life on your terms and means that should the unexpected happen you won’t need to reach for the credit card to cover you, avoiding the potential build-up of debt!
So, debts or savings, which should you choose?
The main thing to figure out is - which has the higher interest rate? In the rare case that your savings rate is higher than your debt rate, it makes sense to put money into your savings first. This is most likely if your mortgage is your only debt, as they tend to be the cheapest form of borrowing, especially mortgages with low fixed rates.
However, in most cases, your borrowing interest rate will be higher than your savings interest rate, in which case it makes sense to use your spare cash to pay off your debt before putting it in savings.
We’ve tried to help visualise this with a quick example:
If you have £1,000 on a credit card at 20% interest, this is costing you £200 in interest a year
If you have £1,000 in a savings account with an interest rate of 3%, this earns you £30 of interest in a year.
So by paying off the debt first you’re £170 better off!
In most cases, you’ll be better off paying off your debts with your spare cash rather than putting it in to savings. This rule is based on the fact that the cost of debt is usually much higher than the benefit gained from savings, as our above example shows. Therefore your pocket gains much more by getting rid of the debt than starting to save. There are a few exceptions, such as borrowing that incurs a penalty if you pay it off early, but we can expand more on that another day!