Save or repay – the age-old question. When you’ve got debt to pay off, but you’re also feeling vulnerable because you don’t have any savings in the bank, that can put you in a pretty difficult position. Both are very important, and both will help you achieve a better, more stable financial position.
But while ideally, you would like to be able to put money into both accounts at the same time, the truth is that a) you might not be able to afford it, and b) it might actually not make financial sense to do so.
So, if you’ve got to only pick one, is it better to save or repay your debt? As you will be able to see, there are certain situations when saving is the better option, and others when it makes more sense to pay off debt first, and then focus on saving.
When Is It Better To Save?
Sure, it’s good to have savings in the bank, but that debt looms over your head constantly, like a dark cloud. Is it worth rushing to pay it off, or are there instances where you can actually relax about it and prioritise saving, instead? Let’s take a look at the situations when it’s smarter to save first, and repay your debt later.
When you’ve got student loans or other 0% or low-interest loans
Conventional wisdom says all debt is bad, but there are sources of debt that don’t come with interest (like family loans), or have a very low interest rate. Or, alternatively, they get written off at some point in the future and there is no point in killing yourself trying to pay them off.
If you’ve got a 0% credit card, for example, you don’t need to rush to pay it off, but be sure to pay it before the grace period expires. But the most common type of loan that you can feel safe paying off little by little is a student loan.
In the UK, student loans have a relatively low interest rate, and the repayment terms are generous. You only start repaying after you graduate, and even then, you only ever pay it back if you earn more than £25,000 per year. You pay 9% of the amount you earn that is over that threshold. And then, the interest is around 6.1%. If your income doesn’t reach £25,000, you don’t need to repay. The loan gets written off after 30 years, whether you pay or not. Gov.uk has more information on student loans.
For these reasons, it makes much more sense to save, because the terms of the loan are so generous. And if you do ever wish to pay off your loan, even ahead of time, there is no penalty for early repayment.
When Is It Better To Repay Debt?
Everyone wants to save, but in certain cases, not only are you not making a financially savvy decision, you could actually be making a very bad one. Saving money per se isn’t ever bad, but it is when you only have the illusion of saving, and you’re actually hemorrhaging money in other place, like a loan with high interest.
When the interest on your loan is higher than the interest on your savings
It’s easy to see why people have the tendency to want to save money, even as they are paying off debt. It eases your conscience to know that you are not just throwing all your money away, giving it to lenders, and that you have a nice little nest egg for emergencies.
However, if the interest you pay on your debt is higher than the interest you make on your savings, then you are actually actively losing money. In fact, not only are you losing money, if both accounts are with the same bank, you are kind of…borrowing your own money and paying it back, at a loss. Let’s explain.
Let’s say you have £1,000 in savings, and also £1,000 in debt. Your debt – be it a credit card or a loan – has a 18% APR attached. Your savings account only produces 1.5%. That difference is massive and it means you are paying an £180 interest charge on your debt, while only making £15 on your savings. With a £165 loss, doesn’t make more sense to pay off any debt first, and then start saving, so you can keep the money you make in interest? The Money Advice Service has a lot of information on debt and how to prioritise it and repay it.
As you can see, there is no right or wrong answer because each situation calls for a different solution. Sometimes it’s better to focus on savings, and other times it makes more sense to focus on repaying debt and then moving on to other things.