When is it better to focus on saving or paying down debt?
As a rule of thumb, if your credit card or loan interest is greater than your bank savings interest rate then simple maths would say it’s better to pay down debt than to save. However there are a few instances where the opposite might apply and we’ll cover those in this article.
When people come to us they’re often overspending and overwhelmed by debt, blindsided by unpredictable expenses and feeling anxious and out of control. Understandably, they want to make paying off their debts their number one priority.
We all know how important it is to save, and to start as soon as you can, because of the power of compound interest. But there are a few instances when foregoing debt repayment for just a short period of time might be the more prudent course of action.
The exceptions to the ‘pay your debts first’ rule are as follows..
#1 Emergency Fund
If you have no emergency fund savings (we recommend a minimum of $2500 to begin with) then it’s really important to slow your rate of debt repayment and focus on building up an emergency cash stash to cover you for life’s unpredictable expenses, like a major mechanical car repair, sickness or the death of a loved one.
Having an emergency fund in place will prevent you from backsliding into credit card use. It’s really important to build the habit of NOT reaching for credit cards, even for emergencies as this will strengthen your savings ‘muscle’ and set you up for a life of financial security and freedom.
After you’ve paid off your high interest unsecured debts, then you can focus on building up an emergency fund of 3-6 months worth of expenses, but initially just having a smaller emergency fund in place will create a sense of security that many people never get to experience.
#2 Saving for retirement
One of the biggest regrets that people have is that they didn’t start saving for retirement sooner. Again, compounding interest is a major reason why you shouldn’t delay paying yourself super or saving for other forms of investment. The sooner you can start, the sooner that you’ll be taking advantage of compounding.
The stock market has been returning on average 9% per annum for the past 100 years. Of course it experiences ups and downs, but overall growth has been in a steady incline.
Small business owners are particularly bad at paying themselves superannuation or investing for retirement in other ways. Their rationale is always that they need to pay suppliers, workers, the government, their own salaries or expenses first.
Not taking advantage of the power of compounding means that small business owners are at a distinct disadvantage compared to salaried workers when it comes to superannuation.
Of course, if you’re paying high interest credit cards or loans it’s better to focus on getting those paid off first before you begin directing all available cash at retirement saving. Otherwise you’ll be going backwards faster than you’ll be be going forwards. And that’s not fun.
Case Study – Lucy
Lucy, a landscape architect, had $8000 in credit card debt at 19% interest when she came to see us. She had a few thousand dollars sitting in a savings account at 2.9% interest, which she said made her feel better that she had managed to save some money. She also had a small amount of redraw buffer in her home mortgage, which would cover her in emergencies. The problem was that she wasn’t making any headway on the $8k debt and the longer that debt hung over her the more money she was paying the bank.
After designing a comprehensive spending plan and factoring in all her expenses, Lucy decided to take her chunk of savings and use it to pay down the credit card. Having her spending plan in place gave her the confidence that she would not need that money in the short to medium term. Paying a chunk off the credit card allowed her to reduce her credit card principal significantly so that she wasn’t paying so much interest.
With her Spending Planner she was able to see the date by which she could have her credit card all paid off, and then she was able to get really intentional about making that happen.
With her new found momentum Lucy was able to pay off the debt within 8 months. She no longer uses a credit card and instead has savings for her goals and also for unpredictable expenses. She says she feels a weight off her shoulders and is much more in control of her finances.
The only time you would ever consider NOT paying off a debt before saving is if the debt is set at zero interest indefinitely (ie there is no time limit before interest charges kick in again). And even so, at some point you’ll still need to pay off the debt, so better to address it sooner rather than later.
Having a small emergency fund of $2500 in place before you start paying down debt is a really good idea, because it means that if you suddenly had to fly overseas for a family funeral or you had a major car repair you wouldn’t have to reach for a credit card to get through it. Having an emergency fund means that you can pay down your debt knowing that you’re far less likely to have to go into debt again.
Once you have your emergency fund in place then you can throw every available cent (that is over and above your basic needs) into paying down debt. Your spending plan will tell you exactly how much cash is surplus to your basic needs and what you can now realistically throw at your debt.
Forget about saving for a bit while you focus all your energy on debt pay down. It’s very hard to do two things at once. You’ll be much more successful if you get your debt handled first. When you see your debt coming down, and the date you’ll be free of it, that will get you even more excited and committed to the process.
And before too long you’ll be able to start saving all the cash you were previously throwing towards debt.
Now that you’ve strengthened your saving muscle, and learned to live on a whole lot less, saving will feel second nature. You’ll be able to focus on building income-producing assets which will improve your life outcomes immeasurably.
Disclaimer: The recommendations in this article are general advice only and should be considered only as part of an overall focus on your personal financial situation. For specific recommendations for your financial situation please seek advice from your accountant or financial planner.