Should I use my savings to pay off my debt?

It may seem like a good idea to continue building your nest egg while clearing any money you owe. However, it could actually make more financial sense to put the money you have saved up towards paying off your debts instead.

To help you decide if this could save you money, Sally Darby of Money.co.uk looks at the benefits and drawbacks involved in using your savings to pay off your debts.

Why use savings to pay off debt?

A good rule of thumb to bear in mind when deciding whether to pay off your debts with your savings is to consider whether you pay more interest on your debt than you earn on your savings. If your debts are costing you more than you earn from saving, doing both at the same time may actually be counter-productive.

In this way it may be a good idea to clear your debts before you begin saving. If you are repaying debts and building savings concurrently, you may end up spending more on interest than is necessary, as your debts will take longer to pay off.

How this works in practice

A credit card with an AER of 15.9% and an outstanding balance of £10,000 would cost you £1,590 a year in interest.

However, even in a savings account paying a post-tax 4% AER - a comparably high interest rate given the current climate - you would only earn £400 worth of interest on £10,000 of savings during the same period.

When you consider that you would pay out more than £1,000 in interest on your debt (£1,190 to be exact) than you would get back from your savings during the course of a year, it begins to put things into perspective.

Remember too that any earnings on your savings are taxable, unless you invest your money in a tax-free cash ISA. You would pay tax on any interest earned in a savings account, but would avoid this if you used the money instead to pay off debts.

If you have debts and savings with the same bank, it could be counter-productive to continue saving while at the same time chipping away at an increasingly growing debt.

This is because you will effectively be lending money to your bank by having your savings with them, which they then lend back to you at a higher interest rate. Clear your most expensive debts first

This particularly applies if you have expensive debts, such as those on credit cards, which may be accruing interest at a dizzying rate. Only paying off the minimum on these while still trying to save may mean it takes years for the credit card debt to be cleared, and cost you more than they need to in interest. If instead you take whatever money you have saved and use it to clear those expensive debts, you'll then have more money freed up to stash away in savings.

By starting with your most expensive debt first and using money you have saved to clear money you owe, you should be out of debt faster than if you tried to keep the two up at the same time. It could be argued that you will then have improved long-term financial health, as you will no longer be spreading your money between debts and savings.

What else should I consider?

Although using your savings to pay off your debt can be the most logical course of action to take in many circumstances, there are some exceptions that should be taken into consideration.

Find out the cost of your debts vs. savings

First you should look at the cost of your debt compared with what you earn from your savings. If the cost of your debt is less than the gain from your savings, you may be happy to maintain repayments on that debt at the same time as adding to your kitty.

For example, if your only debt is a 0% overdraft or a low-interest loan, using your savings to pay off those debts may not be necessary.

Also, some loans come with penalty charges should you pay them off early, which would obviously be an unwanted and avoidable cost. Look into the terms and conditions of your loan to find out if there is a fee for paying it off early; if this is the case you will be better off continuing to make the standard repayments.

Although mortgages can be classified as just another kind of debt, there are different rules involved when it comes to using your savings to pay them off. There may be penalties for paying too early, for example.

Will you be able to borrow again in the future?

If you pay off any loans with your savings, bear in mind that you may not be able to borrow money again after this debt is cleared - especially in the current economic climate where credit is harder to come by. Therefore you may want to keep some of your savings spare if you think you may not be granted credit again when you need it.

Another thing to consider is how much you have in savings compared with how much you have to pay off in debts. If you deplete all of your savings by using them to pay off debts but still have debts left over, you may be putting yourself in a precarious financial position. In this case it may be best to use your savings to pay off your most expensive debt, but retain some of your savings (without topping them up) while making repayments on the rest of your debt.

What if my savings won't cover my debt?

If you have no savings at all to use for clearing your debt, it's advisable that you try to pay off as much debt as you can first before beginning to build your savings. In this way you can deal proactively with your debt instead of spreading yourself too thinly by trying to do both. When you have eliminated or at least reduced the amount you owe, you can then concentrate on building up your savings.

It's advisable to look at your own financial circumstances and decide whether it will be more economical for you to save money but stay in debt, or clear your debts but have less or no savings. Of course if you use all your savings to pay off debts you'll be left with no emergency funds should you need them, so you'll need to be confident that you can borrow more money if necessary.

Many people save money to prevent them from going into debt should the unexpected occur. However if you already have debts, it could be counter-intuitive to keep saving at the same time as trying to pay these off.

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10 February 2011