Your debt's more important than your pension

Here's what you should be doing with your spare cash.

We all have to juggle paying off debts, saving for emergencies and larger expenses, and investing for retirement. But what should your priority be?

I'm going to break these down into some simple rough rules.

Whether to pay off debt or save

If your savings interest rate after tax is higher than your debt rate, it usually makes sense to save. If the debt rate is higher, it usually makes sense to pay off debt.

Here's an example. You're earning 2.9% AER with the Post Office Online Saver. (Read about it and other accounts in The savings accounts that are true best buys.) If you're a basic-rate taxpayer you deduct your tax rate of 20% and your after tax interest will be 2.32%. Now, look at your borrowings, specifically the debt with the highest APR. If the APR is higher than 2.32% (which it probably is), you should pay off that debt before saving. (Don't deduct your tax rate from the debt interest rate.)

Shop around for lower interest rates on debts, perhaps with a 0% credit card, because that can save you money regardless of whether you overpay your debt – provided you continue with the same monthly repayments as before. (The top 0% cards, complete with their fees, are shown in The 16-month 0% credit card showdown.)

Conversely, look for higher interest rates on savings, perhaps through cash ISAs, which are simply tax-free savings accounts. (Read Savers: earn more interest in your ISA for more.)

There are individual reasons why it may make sense to save some money even if your debt interest is high:

• Your contract might not allow you to make monthly overpayments on your debt.
• If you won't easily be able to borrow more in a hurry, you'll need a pot for emergencies or big expenses.
• You might want to start saving a little to get you into the savings habit.

There's a fourth reason to save rather than pay off debt. Some people feel better when they pay for their sudden plumbing crisis or an expensive MOT using savings instead of borrowing more. In financial terms, you'd likely be better off overpaying debt and then borrowing again, but when you're fed up with your debts it can be upsetting seeing the debt grow again.

There are ways to overcome this. At the end of the month when you add up your debts to see how quickly you're reducing them, you add a few thousand pounds to that figure. This is your 'emergency savings'. When you have to dip into your borrowings, the overall figure doesn't then have to rise, and you don't feel so bad.

Whether to pay off debts or save for retirement

When you're talking about saving for retirement rather than paying off debt, it's a little more complicated, because investing is riskier. This applies whether you're using pensions, share ISAs or anything else.

Let's say you're looking at an investment and the provider gives you an example showing a 7% return after tax every year. If you compare that with your debt of 6%, it seems obvious you should invest. However, that figure of 7% is just an example. You could get more, but you could easily get a lot less.

By investing extra cash towards paying off a debt with 6% APR faster, you get a guaranteed 6% return on that investment. If you have to choose between a guaranteed 6% return and just a possible 7% return on the stock market, in a decision balancing risks and rewards, taking the 6% isn't a stupid idea.

Before investing rather than overpaying, take into account the risks. Typically, if you're investing in a variety of investment funds you might hope to get 6%pa or 7%pa on average, but you might not get it. Hence, it would probably be worth paying off debts first if they cost around 5% to 6% APR, or more.

It depends on your investments and your attitude to risk, but here are some general rules:

• Overwhelming debts come first.
• If your debts cost you more than, say, 6% interest, pay them off with your spare cash before investing. This is a low-risk way to get a decent return on your money.
• If your debts cost around 5% interest, the risk and potential rewards are probably more evenly balanced. Consider splitting your spare cash between repaying debt and investing.
• If your debts are much cheaper than that, consider allocating less to debt repayments and increasing your investments.
• You might want to invest just a small amount even if you don't comply with the above rules, to get you in the habit.

Whether to save or invest

Before you start throwing lots of money at investing, which is to take care of yourself in 20 to 40 years, you want to start saving to take care of yourself over the next 12 months to five years. To that end, save for holidays, emergencies and big expenses. You want a large pot of money in case of redundancy or a major car failure, for example.

I think it's OK to invest whilst you're building up a savings pot, because the earlier you start investing the wealthier you're likely to be in the end. However, in the earlier days of saving, consider saving more and investing less. As the savings pot grows, you can then put more towards your investments.

As a broad rule, debts come first, savings second and investing third but, as I've noted above, some overlap is fine, and some reshuffling of this sequence too, provided the expected rates of return are right.

Finally, re-evaluate what you're doing from time to time based on current interest rates and your own financial situation. You may find it suddenly makes sense to stop paying so much to your investments and to pay off a debt, for example.

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