Is It Better To Save Or Repay Debt?

To save or to repay debts… the decision can often be a confusing one – but as discussed here, the answer can be pretty straightforward.

You’re probably thinking repaying your debts is a priority, but what about saving money? Isn’t that also a good idea to help protect your finances in the future?

The fact is, saving and repaying your debts at the same time is likely to lead to you losing money, in real terms.

In most cases, the money you’re saving would be more effective if you put it towards clearing the debts you’re carrying (rather than just making the minimum required monthly payment). Here’s why:

Let’s imagine you’re carrying a credit card debt of $500 and you’re being charged 17% interest on it per year. Meanwhile, you’ve also got $500 in savings with an annual interest rate of 3%.

In 12 months, your savings balance would grow by $15, but your credit card would accrue a lot more interest than this (unless you repaid a substantial amount each month), because the interest rate is so much higher. In simple terms, you’d be spending more money on credit card interest than you’d be earning from your savings.

The interest on a typical credit card debt is considerably higher than that paid on the typical savings account, which means the debt simply grows more quickly than your savings can. For this exact reason, it would make more sense for you to repay your debts as soon as possible to avoid paying interest you could have avoided.

You can always start/continue saving once your debts have been cleared!

There are, however, a few instances in which saving may be more worthwhile than repaying your debts.

For example, if your debt has an early repayment charge, then repaying it straight away with your savings could work out to be more expensive. In this case it might be better to invest the money in a savings account – at least until the interest accrued outweighed any charges.

What’s more, if you’re carrying a debt with a relatively low interest rate, it’s possible you’ll earn more by investing in a savings account than you would save by just repaying your debt.

Finally, if you’ve decided to consolidate your debts with a loan, and have agreed to make fixed monthly payments, some lenders may not allow you to make overpayments. If you’re in this situation, opening a savings account and investing what you would have used to overpay your debts could leave you in a better financial position once your loan has been repaid.

9 Comments so far

  1. optionsdude on May 11th, 2011

    Clearly the math is on the side of going with the higher interest rate and return on that money whether it is from lower interest charges on your debt or a better return on saving. I would caution that it might be best to set some money aside for an unexpected event in case your lines of credit are decreased.
    optionsdude´s last blog post ..Taking Advantage of Price Spike in ONXX

  2. Mike on May 11th, 2011

    I agree…a liquid emergency fund is definitely a smart idea.

  3. Money Beagle on May 11th, 2011

    I’ve always felt that as a general rule (each case is different), a blended approach is best. It allows you to grow savings and also reduce debt. Neither will be ultra fast, but it helps your assets grow and your liabilities shrink, both keys to a good balance sheet.
    Money Beagle´s last blog post ..Liking Something When I Dont Really Like It

  4. Amanda L Grossman on May 12th, 2011

    For me it’s psychological; while we were paying down our debt (we are debt free except for the mortgage now) I still had to get our savings account up to a certain level so that I wouldn’t feel too vulnerable.
    Amanda L Grossman´s last blog post ..5 Ways Retailers Try to Trick Us

  5. Little House on May 13th, 2011

    I’m all for wiping out credit card debt that’s accruing interest. But I think having a small ER fund for emergencies is a good idea too. Saving $500 to $1,000 for unexpected expenses, then focusing on paying off the credit card debt is a good strategy.
    Little House´s last blog post ..How I Selected a Mutual Fund a really boring case study

  6. Everyday Tips on May 16th, 2011

    I often struggle on saving vs paying down debt. However, our highest interest item is our mortgage, which is at 4.75 percent. I do pay a little extra each month, and it will be paid off entirely in about 5 years. However, I think psychologically, even though I may end up with less money in the long run, I may do better if I pay the mortgage off ASAP.

    Tis a tough decision!
    Everyday Tips´s last blog post ..Tips For Setting Priorities And Getting The Right Things Done

  7. Evan on May 17th, 2011

    I am with you Beagle. It is all about balancing liquidity needs/desires vs lowering interest payments going out
    Evan´s last blog post ..Do You Compartmentalize Spending Decisions Also

  8. Doable Finance on May 25th, 2011

    If you could do it, do both. Saving and paying down debt. Debt should not and must not get out of control.
    Doable Finance´s last blog post ..Market Moves Affect Your Personal Finances

  9. Agatha Kulesza on October 3rd, 2011

    I totally agree Amanda! I carried around $30,000 of credit card debt for almost 8 years, always trying to pay it off and pay it off and it never went away. Finally when I decided to just stock up my savings and make debt repayment have little priority, everything changed. My income tripled in 3 months and then I paid off all the debt in 18 months. The credit card interest I paid was well worth it because stocking up my savings gave me the psychological push I needed to finally become debt free. This has worked on several of my clients too so I think it really depends on what each individual responds to.
    Agatha Kulesza´s last blog post ..What Is Financial Stress?

Leave a reply

CommentLuv badge