Paying off debt can make more sense than saving

couple looking at computer

Banks, building societies, the government of the day, our parents – there are lots of people telling us we should save money.

So it’s perhaps no surprise that we feel bad if we don’t put money aside for the future.

But does it make economic sense? Many of us would in fact be better off if we ignored the advice to save and instead paid off our debts.

Debt debate

Let’s say a family has a credit card debt of £1,000 and savings of £1,000 in an easy access account.

The interest rate on the credit card is 19%, which means the debt costs £190 a year. But the interest rate on the savings account is a mere 2% gross, so the annual savings interest is just £20 – before tax (at 20%, 40% or 45%, depending on your tax band).

In other words, the family spends more on the debt than it earns on the savings – £170 more to be precise. So, if the family used the money in the savings account to clear the debt, they would be £170 better off a year.

Tax change

Tax will take a smaller bite from our savings from April 2016, when the Personal Savings Allowance comes into force.

Basic rate taxpayers will then no longer pay tax on the first £1,000 of interest they earn from savings. For higher rate taxpayers, it’s the first £500.

But you should do the sums because you could still save money by not saving money.

The figures are particularly compelling because savings rates are currently so low. The top easy access account pays about 1.65%. Or you can earn about 1.5% in a tax-free cash individual savings account (ISA).

Interest payments

The interest rates on personal loans, credit cards and overdrafts are usually much higher. The typical credit card rate, for example, is about 19%.

In other words, it is more expensive to borrow money than to save. Anyone with savings who also has costly debts should therefore consider using at least part of their savings to help clear their debts.

It makes sense to always pay off the most expensive debts first – and watch out for any penalties.

If you have a personal loan, for example, there could be a penalty of several months’ interest if you pay off the debt before the end of the loan term. It can still make financial sense to clear the debt, but you have to factor the penalty into your calculations.

The cheapest – and biggest – debt is usually the mortgage. You should therefore only pay off, or pay down, the mortgage if you have cleared other, more costly debts. Otherwise, the same calculation applies.

So, if the mortgage interest rate is higher than the savings interest rate, you should consider cutting down the amount you owe on the home loan.

 Substantial savings

The savings can be substantial. Let’s assume you have a £100,000 repayment mortgage at 3.5% over 20 years. If you paid just £50 extra a month, you would clear the debt after 18 years and save a total of £4,700.

Penalties often apply if you clear all or some of your mortgage early, although more lenders these days allow you to pay off up to 10% of the outstanding debt each year without penalty.

Alternatively, you could consider an offset mortgage, where your savings are ‘offset’ against your borrowings.

For example, if you have a mortgage of £100,000 and savings of £10,000 you would pay mortgage interest only on £90,000. You can also usually access your savings in an emergency.

Cheap borrowing

If it’s cheaper to borrow than to save, there’s nothing to gain by paying off debts.

For example, if you have a 0% credit card, you are effectively borrowing money for free. You should therefore keep any spare cash in a savings account where it can earn interest at a higher rate.

Cash cushion

Some people are reluctant to empty their savings account because they feel exposed without a cushion of cash in case of an emergency.

Many experts also advise people to keep the equivalent of three months’ earnings in a savings account (if possible, of course).

But not everyone agrees – and some advisers argue that your emergency fund could be costing you dear.

Let’s go back to our fictitious family. Suppose they used their £1,000 savings to clear their debt, but then the car broke down. How would they pay for the repair?

Well, they could put the bill on the credit card, or possibly take out a loan or overdraft. They wouldn’t be any worse off, and would probably have already saved money on the interest payments.

Of course, if you don’t have access to credit, it’s a good idea to keep some money in a savings account in case of an emergency. You should also resist the temptation to get into a debt cycle. So, once you have paid off a debt, don’t then go on a spending spree.

Pension priority

Pensions are possibly the exception to the rule about prioritising debt clearance over saving.

First, there are generous tax breaks on pensions.

Second, your employer might contribute to a workplace pension scheme on your behalf.

Also, the earlier you start to save into a pension the better as your money has more time before your retirement in which to grow.

You should therefore only prioritise debt clearance over pension savings if the interest payments on your debt are critically high.