Pay Off Debts With Savings
If you have debts and savings then you are seriously overspending far more than
you need to and the only winner is your bank. It’s nice to feel safe and secure
having savings in the bank but while you have debts, you are simply throwing money
away.
The solution to this is simple – you pay off your debts before you save, this may
even include your mortgage. You need to forget the old way of thinking of having
emergency funds “just in case” and getting rid of your debts beats that too.
So why pay off all your debts with your hard earned savings? The following table
explains the basic reasoning behind this idea...
If you had...
|
$1,000 Debts
|
on a Credit card at 18%
|
Interest Cost $180
|
|
$1,000 Saving
|
In a Savings account at 4%
|
Interest Earned $40
|
Pay off the debt with the savings and you are $140 a year better off!
It’s a simple formula, debts usually cost more than what your savings can earn,
so cancel them out and you will be better of.
Banks love us to save and have debts Quite simply, when you give your money to a
bank to save, you are actually lending them your own cash so they can lend it to
other people. The difference between the rate at which the bank borrows money from
you (saving rate) and the rate ot charges others that it lends to (borrowing rate)
is the bank’s profit. So in essence, it will always cost more to borrow than you
can earn by saving.
It is frustrating that so many people have both borrowings and saving at the same
time. And these are often with the same bank. It is effectively the bank lending
you back the money you lent them, except charging you much more!
Exceptions to the rule This will only work if the cost of the debt is much higher
than the benefit gained from savings. You are therefore better off by getting rid
of the debt rather than starting to save. The exception is in the rare occasion
when debts are cheaper than savings, or actually cost so much to pay off its just
not worth it.
Other exceptions to the rule: The Penalty Exception.
If paying off you debt incurs a penalty, as with some loans or mortgages then leave
the cash in a saving account – until the penalty is small enough that it doesn’t
matter. Some people can actually carefully and conscientiously manage their debts
so they are constantly interest free debts. It the interest rate on your debt is
less than the interest on your savings then you can profit from building up your
savings and keeping the debts. So in effect, you are being paid on money lent to
you by the banks for nothing.
There are a number of products where this is possible: 0% overdrafts, introductory
credit card offers such as 0% balance transfers and Student Loans.
So how about an emergency fund?
It is difficult for us to want to draw out our hard earned savings to pay off our
debts. The idea of having cash available in a accessible savings account makes us
feel safe and secure – but you are throwing money away by doing this if you have
debts.
The right thing to do is to still pay off your debts, even if it means using your
emergency fund. However, this doesn’t mean you go cutting up your credit cards.
It is important to keep some credit available in case of a real emergency.
A practical example: Freddie Smartcash
Freddie Smartcash currently has $5,000 saved up which earns him 4% interest, in
case of emergency. But he also has $5,000 on credit cards at 18%. So while his savings
are annually earning him $200 a year, his debts cost $900; overall he is paying
out $700 a year.
Now compare what happens if he pays off his debts with his savings, with not doing
so:
Scenario A: No emergency happens
No change. Keeping both debts and savings costs Freddie $700 a year.
Pay off debts with savings. Freddie now neither earns nor pays any interest,
so is relatively $700 a year better off. All the new cash he puts aside can actually
go towards genuinely saving.
Scenario B: After a year Freddie has to pay $5,000 in an emergency roof fix
No change. Freddie uses the savings for the emergency. This leaves him with
no savings and $5,000 of credit card debt at 18%.
Pay off debts with savings. As Freddie 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 18%.
So therefore, Freddie is in exactly the same position in scenario B, regardless
of what he does. However, before the emergency he was $700 a year better off by
paying off his debts with his savings. Given the risk and likelihood of having to
fork out for an expensive emergency, it is a better bet to pay off your debt with
your savings.
The only issue you need to be aware of is if you cannot re-borrow the cash. With
credit cards its usually fine as they are a ready available source of credit. But
if you debt is a personal loan then there is no guarantee you will able to get another
loan. In this case, an emergency fund is sensible.