Should I Pay Off My Debt or Start Saving?
In an ideal world, we’d have no debt and a ton of savings. But if life isn’t all sunshine and rainbows, then you might find yourself with some debt. In which case, the question I often get is – Is it worth having any savings if I’ve still got some debt?
Well, the simple answer is – do what you want. I don’t care.
Longer and more caring answer is…… well, it’s the rest of this blog post.
What Kind of Debt?
There’s good debt – money that you borrow that ends up putting cash in your pocket each month, and there’s bad debt – money that you borrow that costs you money each month.
An example of good debt would be a buy to let mortgage. You can’t do this, but let’s say you could… you borrow 100% of the cost of a property.
£100k let’s just say. You pay 3% on that money, so you pay £3k each year as interest. You then rent the place out for 6.5% or £6.5k each year.
You profit £3,500 each year because of that good debt.
There’s a whole bunch of other stuff that goes into it, so that’s a slightly dumb example, but it illustrates the point.
Bad debt are credit cards or your car loan. You take a £20k loan out to buy a car, it costs you money each month and you don’t get any payment back.
I guess unless you were a taxi driver, but whatever.
What Kind of Saving?
There are different kinds of savings as well. In its simplest, there’s contingency / emergency savings and then there’s everything else savings (house saving, retirement saving, car saving, holiday saving, etc.).
The emergency savings are there for… you guessed it! Emergencies. Your boiler breaks, your cat needs surgery, you need bail money, etc.
To simplify the answer to the question, we are ONLY going to be talking about;
Bad Debts V Emergency Savings
If you’ve got good debts, good. If you’ve got loads of investments and savings pots for different things, great. But what we’re more concerned about in this post is when you’ve got debts and don’t have any emergency savings.
Let’s play a scenario out. You’ve got no savings and you’ve got a couple of credit cards and a loan and a car on HP.
Not that unusual nowadays unfortunately.
But, what is unusual about you, is you got the smarts, and you’ve gone through all of your income and expenditure and got yourself to breakeven, and hopefully even saving a little extra each month.
So what do you do first, clear your debts or top up your contingency fund?
Maths To The Rescue
From a purely financial calculation perspective, your debts are going to be costing you anywhere from say 4% – 30% per year in interest.
Any savings you set aside are likely to get you anywhere from 0.1% – 2.5% per year in interest.
So clearly, you should put every penny you can towards clearing the debts first.
Another way of looking at it is, every £ you put towards paying down your debt, is the same as investing that £ and getting a 4 – 30% return on your investment. Because that’s the amount of interest you’re saving.
However, if you aren’t a computer, then there is an element of human psychology that does come into play here. It’s comforting to know that you have at least SOME money set aside in case you need it.
The ideal contingency fund is around 3 – 6 times your monthly expenditure. If you spend £2k a month, then anything from £6k – £12k would be a handy contingency fund to have.
But if you’re still servicing debt, you might just want to build up a contingency fund of say £200 – £1,000. It’s enough to cover the majority of things that pop up, and will give you a degree of peace of mind.
Other Factors To Keep In Mind
If you can handle the lack of a safety net of at least some savings, then well done you. You’re doing things like an emotionless boss! But, here’s something to help keep you feeling warm and fuzzy at night.
If you had say £5k worth of debt and over the next 6 months you knock that down to £4.5k. If something comes up, then you can still (hopefully) access the £500 worth of credit that you now have available.
The credit limit on your credit card won’t go down as you pay off your credit card debt. Loans are a slightly different kettle of fish, but my point is, by clearing debt you aren’t removing your ability to borrow again if you need it.
However, something that is randomly important to keep in mind is your credit profile. I’ve talked about it before, but if you can keep the amount of debt you have to less than say 60% of the amount of the credit limit you have, then lenders and institutions are generally a bit more comfortable that you know how to manage your finances.
If you’re always at the limit of your overdraft and credit card limit, then they assume you have no idea what you’re doing. Which could well be true.
So the quick answer was actually;
Yes, you should clear your bad debts before you start worrying about saving.
But that doesn’t take into account the human element, so I thought I’d rabbit on for a bit longer before I got to the point.
When you have a surplus each month, then it’s best to get rid of expensive debt first before you start worrying about saving and investing. The returns you get on investing will often be lower than the interest you’re charged on borrowed funds.
The way we know all this, is by keeping decent records of our financial position. Or keeping our Net worth document up to date.
I give this away in pretty much everything I do because it’s so important, so if you don’t have it, then go on over to this section of the site to see what free or cheap ways I can help you get yourself sorted.