It's common knowledge that you should always have an emergency savings fund, but does that make sense when you have debts to pay? Deciding how best to use your income can be tricky, and the split between saving and paying off debt might not feel obvious.
In the third quarter of 2020, Britons paid back £3.9 billion toward credit card and loan debt. If everyone else is doing it, you might feel like you should be, too. It's not always so clear cut, though.
To help you make the best decision for your and your circumstances, we're going to run through:
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- When you should pay debts first
- When saving cash first makes more sense
- What to do about your mortgage payments
When to pay your debts first
The critical piece of information you need to make this decision is the interest rate that you pay. You can find this in different places, depending on the type of debt you've got:
- Credit cards will have the monthly interest rate included in a message on your statement. To get the APR, or annual percentage rate, you might need to check online or call the card company.
- Fixed-rate personal loans won't ever change the interest rate, so dig out your original loan agreement. You may also be able to find the rate through the lender's website or by calling them.
- For flexible rate borrowing that's not a credit card, the lender should provide you with a periodic statement that includes the current interest rate. Call the company or check your online account if you're not sure.
Once you know how much your debt is costing you, find out how much your savings are earning you. When your debts are costing you more than your savings can make you, it's logical to pay off your debts before building a savings pot.
When you choose this route, be sure to pay off borrowing that has the highest rate first. It may also be useful to shop around for credit cards that will let you transfer the balance to get 0% interest. Remember to beware of transfer fees that can wipe out any savings!
Some borrowing, like personal or car loans, will come with settlement fees. This is a charge of up to two months interest when you pay the balance before the scheduled date. Your lender can tell you this figure, and you can check whether it'll be worth the cost.
When to prioritise savings
If you've been savvy with your credit card borrowing, you might have your unsecured debts at 0% interest. At this point, it makes sense to save as much cash as possible to earn interest. Then when your interest-free period ends, you can pay it off with your savings.
You should also consider what you'll do when a rainy day arrives. When you pay off credit card debt, the credit limit should remain available to you in case of emergencies. Paying off a loan usually closes off access to the money; if you lose your job, you probably won't be able to access new lending.
In this case – when you can't be sure you can borrow money again – it is sensible to have a pot of savings to draw on.
Not too keen on potentially building up credit card debt again? When you have known expenses that you can't manage from your monthly budget, you can have a savings pot for them. For example, putting away money each payday for the grandkids' Christmas treats will help you budget.
Should I repay my mortgage before building up savings?
The most significant debt you'll likely ever have is your mortgage. It's probably the lowest interest borrowing you'll ever get as well!
There are significant savings to be had with paying off your mortgage early. The interest is low, but you pay it over a long time – making extra payments can take years off your debt and thousands of pounds off your interest.
You can be charged fees for paying off a mortgage early. Every mortgage lender works a little differently. If you're in the discount period of your mortgage, there will be a limit of how much you can pay down each year before fees of around 3% kick in.
Chat with your mortgage advisor or lender to get full details about how making extra mortgage repayments can affect your finances. Remember, it won't be easy to borrow the money again in tougher times, so have an emergency pot of savings ready before you start to pay down your home loan.
Extra pension contributions or overpaying a mortgage – which is best?
When you've got wiggle room in your monthly budget, you might consider topping up your pension rather than pay off your mortgage. Taking into account the tax benefits and the potential for a higher return on pension investments, you may be better off adding to your pension.
Other benefits of paying more into your pension include:
- Tax rebates on everything you invest in a pension up to around £40,000
- Your employer should match at some of your higher contributions
- You can lock in a higher income when you buy your pension annuity with a bigger pot
Whilst some of the drawbacks compared to paying off your mortgage include:
- Taking the risk of investing – your pension can go down as well as up
- Overpaying your mortgage could help you get better mortgage rates in the future – you'll miss out on this if the cash goes into your pension
- You can buy a bigger or second home with the equity you build through increased mortgage payments, whereas paying into your pension locks money away until you're 55
Everyone's financial situation is different, so speak to a financial adviser to dig into the numbers and what will work for you.
Should I clear debts or save?
We spoke to The Female Money Doctor, Dr Nikki Ramskill, who told Pension Times: "I think if it's do-able for you, saving while paying off debt is a great way to help your money mindset (and your net worth!).
"By shifting the focus away from debt and more onto seeing your savings grow, you're creating an abundance mindset which is a much healthier way to think about money. Having a nest egg of savings can also help to keep you out of debt. Having an emergency fund and slush funds for things like Christmas, birthdays and school holidays can help to stop you using credit to fund these (often large) expenses.
"Of course, personal finance is personal, so prioritise according to how your finances are, but having savings in the bank puts you in a much stronger position than waiting until you are debt free."
Your circumstances will dictate whether you should put your money into paying off debt or paying into savings. High interest rates on credit cards and loans plus low savings rates usually mean your debts should get priority.
Having a small pot of savings can be useful to either help you budget for general expenses, or when you can't be sure you'll have access to borrowing.
Your mortgage is a different set of calculations again. You may be better off topping up your pension, but be sure to run the numbers and consider what your retirement might look like.