Should I: save money or pay off debts?

It’s important to have emergency savings, to help with the little (and not-so-little) emergencies. This could be to replace the fridge, fix the car, or cover the cost of living between jobs. See our guide on Rainy Day Funds.  

However, debts will be compounding – as the interest charged by the lender will add to your original debt and increase it. The longer you leave a debt unpaid, the more it will generally cost. 

So, if you have debts to repay and want to start saving money too – what should you do? 

An Example 

Consider the impact of interest. 

If you had: 

£1,000 in savings with 1.5% interest - this earns you £15 a year

£1,000 on a credit card with 18% interest - this costs you £180 a year

If you chose to pay off the debt by using your savings, you would be £165 a year better off. 

This will result in no savings, but also no debt.

No Savings? What If I Need It? 

Let’s say that after a year debt-free, you suddenly have to pay £1,000 for an emergency burst pipe. 

• If you used your £1,000 in savings to pay the bill, then you are left with no savings and £1,000 on a credit card with 18% interest. 

OR

• If you had paid off your credit card debt and have no savings remaining as outlined above, you might now borrow £1,000 with an 18% interest rate.  

The outcome is the same – except that in the years between paying off the loan and the new debt, you were £165 better off a year.  

If you don’t have pre-existing savings which can be used to pay off your debts, then consider if increased repayments can help.  

Pay Off More Debt Instead 

Most of the time it’ll be recommended that you use your extra income to speed up your debt repayment. This is because debts increase in cost over time, so by reducing the time that you are in debt then you will be better off. 

However, if the amount of debt you have is too large to pay off any quicker or if there are early-repayment fees then it may be best to put your excess income into a savings pot. This will help you to live a more comfortable lifestyle, it can give you that extra security in case of a job loss or car breakdown, for example – and could provide you with the necessary finances to keep up your debt repayment in hard times.  

Saving or Repaying 

Here are two practical examples -

A debt of £2,500 which you had planned to pay off over two years. 

The annual percentage rate (APR) is 4.4% with no early repayment fee. 

If you stuck with your original plan of paying £110 per month, it will cost you £113 in interest. 

However, doubling your repayment to £220 per month will reduce the total time to 12 months, and overall cost you £56 less.  

In this case, it might be advisable to put your money into debt repayment rather than into savings. Once out of debt, you could continue putting aside the same amount of money into a savings account and watch it grow!  

This is typically the advice you will be given when interest rates are high, as this is when borrowing costs more. 

Alternatively, you might think that the saving of £56 over two years isn’t all that much and you’d rather stick to your original plan. The extra income of £110 could go into an easy access savings account to build up your emergency fund. This plan would mean that instead you could save up £2,640 and pay off your £2,613 debt by the end of two years, at a cost of £113. 

Let’s look at another example. 

• A debt of £25,000 which you had planned to pay off over ten years. 

• The annual percentage rate (APR) is 4.4% with a one-off early repayment fee of £500.  

• If you stuck with your original plan of paying £257 per month, it will take 10 years to clear and cost you £5,818 in interest charges alone. This doesn’t include any potential late-payment fees!  

• However, an increase to £500 per month will reduce the time to 4 years 8 months and cost you only £2,608 in interest.

• Even with an early repayment fee of £500, this will work out to be £2,710 cheaper – plus, you’ll be out of debt in more than half the time!  

However, you’ll need to ask yourself if you’ll be able to keep up this increased repayment for that number of years. It may be wise to save up a pot of emergency money to buffer unexpected living costs first – and then begin this aggressive repayment plan.    It depends on your situation and what you believe you can manage.   

Keep up your minimum debt repayments  

However, you decide to spend or save your income, make sure you keep up with your household bills, mandatory debt repayments, and have enough money for food and other living costs.  

If you think that you can put more money aside once these essentials are paid, either as savings or towards your debts, then there’s a few things to think about.