When saving money costs you £650!

If you're trying to save, you need to do take this crucial step first - or you could lose hundreds and hundreds of pounds...

It's an age-old dilemma.

Should you save your spare cash or use it to pay off your debts?

Psychologically, it makes sense to save. After all, it feels good to see your bank balance bloom, and once interest starts rolling in, you'll feel like your money is working hard.

But saving while you still have debts is one of the worst financial mistakes you can make. Building a nest egg may sound logical, but if you leave interest to rack up on your debts, it can put a serious dent in your finances.

I'll let the numbers do the talking.

The £10,000 question

Let's say you have £10,000 worth of debt on a credit card which charges 15.9% APR. You put £250 a month towards this debt.

Fast forward three years, and you've sliced your debt in half, leaving £4,473.14 to pay at the end of the term.

During this period, you've also managed to put £100 a month into a regular savings account which pays 5%. After three years, you'd have built up £3826.60 as a basic rate taxpayer. Sounds like a healthy nest egg, and so a smart move, right?

Wrong.

If you'd put that £100 towards your debt instead of your savings, by the end of the three year term, you'd have paid off your £10,000 credit card bill entirely, and you'd be debt-free.

Ok, you'd have no savings to show for it, but by paying off your debts instead of saving, after three years, you'd save yourself nearly £650 in interest payments.

Counter-productive

As the recession continues to claim more victims in the job market, you probably think I'm crackers to tell you to ditch your savings. After all, if you lost your job, you'd be in a bit of a pickle if you had no savings.

But paying off your debts still makes sense, even if an emergency should arise.

Let's say that two years into your debt-busting plan the worst happens. You lose your job and need £2,000 to tie you over, fast.

If you took the £2,000 from the savings nest egg you'd built, you'd owe £2,727.30 of your original £10,000 debt at the end of the three year term (minus the savings).

However, if you borrowed the money from your credit card, by August 2012, you'd have just £2,176.22 left to pay.

This gives you a saving of £551.08 - even though you borrowed from your credit card.

The saving depends on you being able to borrow the £2,000 at 15.9% (by putting your purchases on the credit card), and relies on you continuing your payments and savings plan as normal. The more you can afford in monthly payments, the bigger the saving. Have a play around with these savings and credit card calculators to see how much you could save.

But with savings rates so low at the moment, the argument to pay off debt is even more compelling, and hopefully this simple illustration showsthat paying off debt is nearly always the best solution.

Breaking the rules

Nearly always, because there's always an exception to the rule - in this case, two.

The first is if you've managed to transfer your debt onto a 0% balance transfer credit card.

As long as the interest you're paying on your debt is lower than the rate you're getting on your savings account, it's smart to continue to save and earn interest on your money.

Read Four steps to the perfect credit card balance transfer to find out how to make the most of 0% deals.

The other way you can save without paying off your debt is with an offset mortgage, which allows you to offset your savings against your debts. So while you're saving, you're also reducing your debts. Yes, you really can have your cake and eat it.

Confused? Basically, the amount of savings you have is balanced against the amount of debt you owe on your mortgage. So, if you have £50,000 saved, and keep that money in a savings account provided by your mortgage lender, you won't pay mortgage interest on £50,000 of your mortgage debt. Unfortunately, you won't earn any interest on that £50,000 either - but as you're effectively earning interest at the rate of your mortgage, tax-free, it's probably worth it.

Several lenders offer offset mortgages, including First Direct, Intelligent Finance, RBS and Woolwich, although most deals are best suited to affluent customers.

You can find out how much you could save by using our very own offset calculator.

Does this strategy suit you?

Of course, there will always be those who prefer to see a positive balance in their account, even if they have debts to pay.

If you're a first time buyer saving for a deposit on a house, you could also argue that it's worth saving up. Big deposits rule in these credit crunched times, so you may be able to get a much lower rate on your mortgage if you can put down a large deposit.

Just remember that while you still have debts, the interest that racks up will eat into your savings, and this may affect the amount you can borrow when lenders assess your affordability.

No matter how much you want to protect your savings, holding onto a positive balance while still in the red is not a good idea.

So make sure the psychology of saving doesn't rule your wallet, as it can end up costing you more than you bargained for....

More: Watch out for this savings trap! / 15 cracking credit cards