Repay debts or save?

How to protect and max your cash

Those with loans or credit cards AND savings are seriously overspending but the solution could be simple. Many should just pay the debts off, before you save. With credit card you might even want to forget the old 'must have an emergency savings fund' logic as getting rid of debt may beat that too.

More 'paying off debt' guides...

Should I pay off my student loan?
Should I overpay my mortgage?

Yes, paying off debts with savings makes sense...

We can almost hear the dismay at this suggestion: "What? All we hear about is that people don't save enough and here I am, trying to do it, and you say don't! What are you talking about man?". So let me explain the basic reasoning straightaway...

 £1,000 debt on a credit card at 23% costs £230 in interest over a year.
 £1,000 saved in a savings account at 5% earns £50 in interest over a year.

 So pay off the debt with the savings and you're £180 a year better off.

It's that simple. Debts usually cost more than savings earn. Cancel them out and you're better off.

What about tax?

Savings interest can also be hit by tax too, though it's generally less of an issue than it used to be. Since 6 April 2016, the personal savings allowance (PSA) means you can earn some interest without paying tax:

- Basic (20%) taxpayers can earn £1,000/yr of interest tax-free.
- Higher (40%) taxpayers can earn £500/yr of interest tax-free.
- Top (45%) taxpayers don't get a PSA.

Remember, that's the INTEREST you can earn. That means as interest rates have gone up, the amount you can have saved tax-free has gone down. So although many people still won't pay tax on savings, if you earn a lot of interest you might do. If so, factor that in – it makes paying off your debts even more attractive.

Banks love us to save and have debts

Put simply, when you save money you're actually lending your cash to the bank for it to lend on to other people. The difference between the rate at which it borrows money from you (the savings rate) and the rate it charges others (the borrowing rate) is its profit. Therefore, on the whole, it'll always cost more to borrow than you can earn by saving.

This is why I find it deeply frustrating that many people have both borrowings and savings at the same time, often with the same bank. Essentially the bank is lending you back the money you lent it, except charging you much more. 

Think about this, it's actually quite shocking. I once made a speech to the Building Society Association conference, which was puffing out its chest at how much better than banks they were.

So I asked how many of their savings managers' salaries were based on the value of savings they brought in. Many were. Then I questioned how many got the branch staff to ask people opening savings accounts if they had debts. Not one!

Two exceptions to the rule

The rule is based on the fact that the cost of debt is usually much higher than the benefit gained from savings. Therefore your pocket gains more by getting rid of the debt than starting to save. The exceptions are in the few occasions when debts are cheaper than savings, or cost so much to pay off that there's no point:

  1. The penalty exception. If you're locked into the debt, so that paying it off incurs a penalty, as with some loans or mortgages, then leave the cash sitting in a savings account until the penalty's small enough that it doesn't matter.

    More details on loan lock-ins are in the Cut the Cost of Existing Loans guide.

  2. The interest-free / very cheap debt exception. If the interest rate on your debt is less than the amount your savings earn after tax then, providing you're financially disciplined, you can profit from building up savings and keep the debts. In effect, you're being paid on money lent to you by the banks for nothing

    There are a number of products where this is possible: introductory 0% credit card offers (see Best Balance Transfers and Purchase Cards), 0% overdrafts (see Best Bank AccountsStudent Account and Graduate Account articles) and Student Loans (see Should I pay off my student loan?).

Should you have an emergency fund?

As a raw answer, yes. It's generally worth having three to six months' worth of expenses put aside in savings in case of an emergency. Certainly for loans, mortgages and other fixed repayment borrowing.

Yet there is an exception for credit cards. Emotionally, many will find what I'm about to say difficult to deal with. The idea of having some cash in a savings pot feels safe, especially as traditional budgeting logic berates us to always have an 'emergency cash fund'.

While it's the right aim, for anyone with expensive credit card debt – where you can borrow more without applying for a new product – there's a better way. 

If you were to pay off your debt with your savings, but without then cutting up your credit cards, it's important to keep the credit available in case of a substantial emergency (and substantial means just that, your roof falls in or you can't feed the kids; not a new TV).

A practical example

Johnny currently has £5,000 saved up, earning 5% interest, in case of emergency, yet he also has £5,000 on credit cards at 22%. While his savings are earning him £250 a year, his debts cost £1,100. Overall, he is paying out £850 a year.

Now compare what happens if he pays off his debts with his savings, with not doing so:

Situation A: No emergency happens

  • No change. Keeping both debts and savings costs Johnny £850 a year.
  • Pay off debts with savings. Johnny now neither earns nor pays any interest, thus is relatively £850 a year better off, and all the new cash he puts aside can go towards genuinely saving.

Situation B: After a year he has to pay £5,000 for an emergency roof fix

  • No change. Johnny uses the savings for the emergency. This leaves him with no savings and £5,000 of credit card debt at 22%.
  • Pay off debts with savings. As Johnny has no savings, he has to borrow the £5,000 on his credit cards. This leaves him with no savings and £5,000 debt on his credit card at 22%.

In other words, Johnny is in exactly the same position in situation B, regardless of what he does. Yet before the emergency he was £850 a year better off by paying off his debts with his savings.

The risk here is in the meantime the credit card firm cancels his debt facility, but that is rare, and you should have notice.

So overall, whether an emergency happens or not, the best result is to pay off your credit card debts with your savings.

The disciplined exception

Those making a concerted effort to repay serious debts may find the idea of reusing credit cards a real danger. Yet while it isn't a sensible strategy to have an emergency fund, as there's no guarantee you'll ever need it, there is some justification for making small savings provisions for specific future events.

For example, saving a small amount each month towards Christmas (see budgeting article), for those who can't trust themselves to stick to the limit on credit cards, is a sensible personal financial strategy. Yet keep it to limited amounts of cash.

Should you pay off your mortgage with savings?

Many people don't think of their mortgage as a debt, but of course it is. However, the key difference is mortgages are usually at a much cheaper rate and less flexible than other forms of debt. Yet the maths is similar...

 £10,000 mortgage debt at 6.79% costs £679 in interest over a year.
 £10,000 saved in a savings account at 5% earns £500 in interest over a year.

 So pay off the debt with the savings and you're £179 a year better off.

In this case the difference between debt and savings is much smaller, but you're still better off using the savings to clear your mortgage debt.

But some people still have cheap fixed mortgages at sub-2% rates, which means paying them off with savings that could be earning 5% doesn't make sense. However, it's not quite so clear cut, as mortgage rates have risen, meaning that you'll likely move on to a 5%-plus deal once your cheap deal ends. So it could make sense to overpay as much as possible before that happens to minimise the debt.

As it's complicated at the moment, for full details, including a specially designed calculator, read the dedicated Should I overpay my mortgage? guide. 

Pay off the most expensive debts first

Sadly, many people have much more debt than savings. So even if you use all your cash to pay them off, you'll still have debts left. Therefore, it's important you prioritise using your savings to get rid of the most expensive debts.

Before you do this, check to see if you can lower any of your debts' interest rates.

Once your debts are as cheap as they can be, list where they are and the amount of debt that you have. Then use your savings (or spare cash) to pay off the most costly debts first. All this done together should massively reduce your costs.

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