Should You Save Or Pay Off Debt?

Accepted wisdom is that we should all save for emergencies, even if we have debts. One Fool disagrees, and shows why.

I think most financial commentators say that everyone, including people with debts, should save an emergency fund. However, I disagree.

The whole point of emergency savings is to have some money aside to prevent you getting into debt should something unfortunate happen. But, if you already have debts, it's counter-intuitive to save. Either it's cheaper to save and be in debt, or it's cheaper to be out of debt and have no savings.

Rather than confusing you further, I'll give you an example. For those of you interested in the maths, I'll show some figures first in 'The example'. Anyone who just wants a summary can skip to 'So who is better off?'

The example

Let's say that you have a credit card, or several credit cards, with £13,600 of debt on them. The interest rate you're paying is around the average, at 16% APR. (It's probably 15.9%, but let's not respect the psychological pricing!) The minimum repayment in the first month is £272, so you decide to set your monthly repayments at that figure.

Let's also say that, after paying all your household bills and after deducting money for entertainment and luxuries, you have £100 per month left over.

Now, let's say that you want to build up three months' income as an emergency fund. (Most commentators say three to six months is sensible.) After tax and pension contributions, your income is £1,200 per month, so you need £3,600. Therefore, you start transferring this £100 per month into a savings account, expecting to take three years to save up your pot.

Three years later, your savings, including interest at a generous 6% AER, now total £3,880 (or less for higher-rate taxpayers). During this time your credit-card debt has gone down to £9,450. If you deduct your savings from your debt, the figure you have is £5,570 remaining debt.

However, let's say you don't save the £100, but add it to your debt repayments instead. You're paying off £372 per month on your credit card instead of £272. You have no savings at the end, of course, but your debt is just £4,860.

So who is better off?

If you have debts of £13,600 and you choose between paying off an extra £100 per month or putting that money into a savings account. After three years:

• Savers would have total debt after savings of £5,570.
• Non-savers who repaid their debt faster have a total debt of just £4,860.

Comparing the two figures, you'll see that you're more than £700 better off if you choose to pay your card debt quicker! (Higher-rate tax payers benefit even more.)

I also worked out that, even if you saved in a tax-free ISA at 6%, you'd still be over £600 worse off than if you threw your spare cash at your debts.

What happens if there's an emergency?

Let's say that at the end of the third year there is an emergency and you need £3,000 quickly. Whether you have to take it from your savings or borrow an additional £3,000, you'll still be better off if you didn't save:

Total debt after deducting savings

As you can see, you're still more than £700 better off after the emergency if you have chosen to repay your debt faster.

Exceptions to the rule

As long as the debt interest you're paying is higher than the savings interest you're earning, it makes more sense to pay off your debts faster. This means that most people should pay off their debts first before saving, because banks normally charge us a lot more interest than they pay out.

However, this won't apply to everyone. If you are a rate tart -- which means you constantly switch your debts between 0% cards -- you might prefer to save, as you'll probably be better off.

But it's not all about maths

Before you follow my suggestion and pay off your debts faster instead of saving, there is something else to consider. As you have no savings, you must be confident that you can borrow more money again in a hurry, if necessary. So you need to know that you can transfer credit to your current account quickly.

You can check that transfers of credit to your current account are allowed with a quick call to your card provider. Alternatively, our discussion-board users might know.

Of course, in the event of an emergency, you could temporarily use your credit card for your regular purchases, and then you can use the money already in your current account for the emergency.

But if you find that the only way for you to get the money off your credit card is to draw it out from a cash machine, then this route is not for you. Cash-machine withdrawals are very expensive in fees and interest, so you should save.

One more exception to my rule: credit-card providers might lower your credit limits as you reduce your debt. This means you won't easily be able to borrow quickly. However, this is only likely to happen if you've frequently failed to pay your bill on time.

Thankfully, most people should have no trouble transferring balances to their current accounts, so paying off your debts faster instead of saving makes sense for the majority of people.

If you're concerned, you might want to cut down on luxuries and consider getting income protection insurance with the savings you make. Also, if the worst does happen, don't immediately borrow on your existing credit card. You may find a new 0% deal or an unsecured personal loan are cheaper alternatives.