Regularly adding to your savings may seem like the sensible thing to do, but here's why you're better off focusing on your debts instead.
Here at the Fool we have always been big fans of saving, even if you have debts to pay. And in times like these, it's even more important to have some money stashed away for a rainy day -- ideally at least three months' salary.
Of course, the whole point of saving is so that we don't land ourselves in a bucket full of debt if something goes wrong.
Fair enough. But what happens if you are already in debt? Does it really make sense to be saving money when you could be putting it all towards paying off your debt?
What's more, with interest rates on savings accounts going down the pan, there's not much of an incentive to save anyway. So would you be better off simply focusing on paying off your debt?
Scenario A: The saver
Let's say you have credit card debt of £10,000, and you are paying an average interest rate of 16% APR. You decide to set your monthly repayments at £200.
At the same time, you decide to put some money into a savings account which is paying 4.5% AER -- a fairly decent rate at the moment. Once you have deducted money for your household bills and other expenses, you have £100 to spare to put into the account.
It will take a total of 6 years, 11 months to pay off your credit card debt in full. And over that period, you will have paid out a total of £24,900 in a combination of savings and debt repayments.
At the same time, you will have built up £9,417 in savings (this will be less for higher-rate taxpayers). That's quite a tidy little sum, right?
But let's try a different scenario.
Scenario B: The debt payer
Let's say you decide not to pay into a savings account and instead use the spare £100 to add to your debt repayments. In other words, you will be paying £300 towards your credit card each month, instead of £200.
Ultimately, by doing this, you will pay off your debt more quickly. In fact, it will take you just 3 years, 9 months to repay it -- 3 years, 2 months earlier than in scenario A. Woo-hoo!
But there's more.
To take the period up to the full 6 years, 11 months (from the first example), you still have 3 years, 2 months to save. So let's say that, for the next 3 years and two months, the £300 you had previously been paying towards your debt each month is put into a savings account.
With an interest rate of 4.5% AER, you will have saved a whopping £12,081 over the period! That's £2,664 more than in scenario A.
What's more, to achieve this figure, you haven't paid out any more money than in scenario A. Just take a look at the chart below:
| Debt repayments per month (over 6 years, 11 months) | Remaining debt at end of period (6 years, 11 months) | Savings per month (over 6 years, 11 months) | Total spent in debt repayments and savings over period (6 years, 11 months) | Total savings accumulated @ 4.5% interest at end of period (6 years, 11 months) | ||
|---|---|---|---|---|---|---|
| Scenario A | £200 | £0 | £100 | £24,900 | £9,417.15 | |
| Debt repayments per month (over 3 years, 9 months) | Remaining debt at end of period (3 years, 9 months) | Savings per month (over 3 years, 2 months) | Total spent in debt repayments and savings over period (6 years, 11 months) | Total savings accumulated @ 4.5% interest at end of period (3 years, 2 months) | ||
| Scenario B | £300 | £0 | £300 | £24,900 | £12,080.68 | |
Difference between scenario A and B: | £2,663.53 | |||||
It's pretty impressive stuff!
In fact, I also worked out that even if you saved your cash in a tax-free ISA at 4.5%, you would still be £2,535 better off by paying off your debt quicker.
Exceptions
The above calculations only make sense if the debt interest you're paying is higher than the savings interest you're earning. But let's face it, in the current climate, that's pretty likely!
That said, if you are a rate tart, and constantly switch your debts between 0% credit cards, you might prefer to save -- particularly if you can get a high savings rate. As you're not paying any interest on your debt, you may be better off saving.
Of course, if you have no savings at all, you may not feel comfortable having no safety net to fall back on -- particularly given the rapid rise in redundancy levels. So in that case, you may still want to save.
But mathematically-speaking, you are clearly better off prioritising your debts over saving. And of course, successfully paying off your debts will set you up for a better financial future.
So overall, I would say if you do have a lot of debt, focus on reducing that first. After all, as soon as you are debt-free, you can concentrate on becoming a good saver! Good luck!
More: Debt: The Warning Signs And What To Do | The 0% Credit Card Of The Year