Putting ‘spare’ cash into a savings account for life’s little emergencies is something many of us have been taught to do from an early age.
But what if you also have a lot of debt to repay? Should you build up your savings or focus on paying down debt first?
Here, we take a closer look at your options…
Should I prioritise paying off debt over saving?
It can be reassuring to have a pot of cash to fall back on if the boiler suddenly packs up or you need urgent car repairs. But if you also have a lot of borrowing (loans, credit cards, mortgage), it can make more financial sense to clear your debts before putting money into a savings account.
The reason for this is simple: you’ll probably pay a lot more in interest on your borrowings than you will earn in interest on your savings.
Let’s look at an example. If you had £2,000 on a credit card charging an interest rate of 19%, the interest cost per year would be around £380. If you had the same £2,000 in a savings account paying 1%, the interest generated would be £20 per year.
In other words, you would be £360 a year better off by clearing your debt first. That’s quite a saving.
Does tax change anything?
Previously, savers would have had to pay tax on savings interest, but thanks to the introduction of the personal savings allowance (PSA) in 2016, most people no longer do.
Having said that, if you earn a lot in interest (£1,000 in a year if you’re a basic rate taxpayer, £500 in a year if you’re a higher rate taxpayer), you may have to pay tax on some of your savings interest, in which case it makes even more sense to clear debts first.
Are there any exceptions to the rule?
There are a few cases where the rule of paying down debt before saving doesn’t apply.
This is usually because the interest rate on the debt is less than the amount earned on your savings, or because there are high fees involved. For example:
Interest-free debt
If you are borrowing on a credit card that offers 0% interest for a set time, putting money into a savings account rather than clearing your debt is usually more cost-effective. However, there are two conditions:
- your savings account needs to pay a decent rate of interest – not an easy task these days, but even if it’s 1%, you’ll still save money
- you should have a payment plan in place to clear your credit card debt before the 0% offer ends and interest has to be paid.
Debt that charges early repayment fees
Some debts, such as mortgages or loans, can charge hefty fees if you pay off the amount borrowed early.
In the case of a mortgage, this can often work out to be thousands of pounds, which means clearing your debt rather than saving can come at a far greater cost.
The only time this might change is if the early repayment charge gradually reduces and becomes small enough not to matter.
With some mortgages, the early repayment charge only applies if you repay a certain amount, so you could find out what this is and repay less each year, thus making your money work as hard as possible.
Student loans
Student loans work differently to most other types of debt – you don’t have to pay anything back until you earn a certain amount, and your loan gets written off after 30 years (if you graduated after 2012).
This means that overpaying on your student loan isn’t always as cost-effective as it might seem – after all, you could end up paying off a debt you didn’t need to clear.
Clear the most expensive debts first
When paying down debt, the best way to do so is to focus on the one charging the highest rate of interest first, particularly in the case of credit cards. For example:
- card A charges 20%
- card B charges 15%
- card C charges 9%
In this case, you should focus on putting as much money as you can towards the debt on Credit Card A, whilst still keeping up with your minimum monthly repayments on cards B and C.
Once you’ve cleared Credit Card A, you can put more money towards paying off card B, and once you’ve cleared card B, focus on paying off card C.
To save yourself even more money, it’s worth moving existing credit card debt to a 0% balance transfer card to reduce the amount of interest you’re paying (remember there is usually a transfer fee to pay, calculated as a percentage of the amount you’re moving).
Or you could consider taking out a new personal loan at a cheaper rate to pay off a more expensive one (make sure you check for early repayment fees first). Check out our guide to debt consolidation.
So, should I have any savings?
Some people argue that it’s best to have an emergency savings fund of at least three months’ worth of outgoings.
However, if you have credit available, ideally through a credit card, it still makes sense to clear your existing debt before saving. Any emergency expenses can then be paid for with your credit card.
Make sure you only use your credit card for essential purchases however – don’t use it to go on a shopping spree and build up more debt you will then need to repay.
Once you have cleared your debts and you are comfortably keeping up with your mortgage repayments, you can then start contributing to savings on a regular basis.
