Saving or paying off debt - which is the best option for the Limerick public?

I received an email from a reader last week enquiring about whether she should try and accelerate the repayment of some debt she had or should she use what surplus funds she had each month to save instead?
And it was a very good question and I wanted to share my answer with you because I’m sure others may have thought about the same thing.
And it can be a hard one to answer and how do you actually choose one over the other to make sure you’re doing the right thing?
Should you focus exclusively on one or are you better off working on both at the same time?

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One well known financial guru in the United States is a man called Dave Ramsey, and his advice is that after you have an emergency fund in place you should focus all of your energy and extra funds into paying off debt. He says don’t put money into savings or pensions, just use all of your extra funds to pay down debt, high interest debt in particular and once that is done you can then focus on increasing your savings.
But then others will argue that the longer you wait to start saving, particularly when it comes to putting money into your pension for example, the more you have to set aside later on. If you start saving earlier you get the benefit of compound interest on your savings and you get tax relief on your contributions and you could get higher employer contributions as well. And these are all lost if you ignore saving at the expense of your debt.
Anyway, I wanted to crunch the numbers for this woman to see which was her best course of action.
And I’m going to reveal what I found but first let me give you some background on her:
-Age 34
-Owes c. €10,000
-Monthly repayment is €203
-Interest rate on loan c. 8%
-Term remaining on loan was five years
-Existing savings €4,000
She had an extra €100 each month which she felt she could either pay towards this loan and accelerate the repayment of it, or lodge into a savings account
She was torn between the two and because she didn’t feel she had enough savings in place she was leaning more towards putting that extra €100 into a savings account.
And you might think, why on earth would she consider saving money into an account that would earn perhaps 1% or less when she could be using it to repay a debt costing her 8%. And you’d be absolutely right, if she had reasonable savings in place which she did. And she was also in very stable, permanent employment as well so there was no threat to her job, which was important to know and factor into the decision making process.
And just to point out in some circumstances when people have healthy savings in place that are beyond what they’d need in an emergency fund in place then it’s nearly a no brainer to focus on paying down debt with surplus monies.
Because paying off debt with extra funds each month means you’re getting a guaranteed return of whatever the debt is costing you and with her that rate was 8% and it would be really hard to match or beat that return in an investment account without taking on probably significant risks.
And why would she need to take any risk?
But despite this some people can be reluctant to use surplus monies to pay off debt and they leave them languishing in accounts where the rate of return is close to 0%. They don’t see the value in paying off debt because they would prefer to hold on to their cash.
And that can be a big mistake.

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The only reason you shouldn’t use surplus monies and or use existing savings to clear off debt would be if it means you’re clearing out all of your savings. In this instance it would be unwise to do so, even if it made financial sense to, because you may need those emergency funds in the event of an illness or if you were made redundant but if you have these events covered, then I’d say your best course of action would be to pay down debt.
I mean if any bank ran an advert tomorrow advising they will give you a guaranteed return of 8%, I think it would get your attention and you would want to take advantage of this return and you’d open the account and you’d be right to. Of course this isn’t going to happen but you can make it happen by using surplus funds to accelerate the repayment of any debt.
And the return could be even higher particularly if you have credit card debt where rates can be as high as 23%. So, rather than thinking you are wasting your money clearing debt like this off, change your mindset to thinking of the incredible you’re going to get.
Okay, back to the lady who sent me the email.
My initial thoughts were that she would be financially better off focusing on paying off her debt but I didn’t know for sure so I wanted to crunch the numbers to make sure I was right. And I was going to look at the outcome of each strategy over a 10 year period.

Option 1 (Use Surplus Funds to Repay Debt – None towards Savings)
If she overpaid by €100 she would reduce the term of her loan by 22 months (now repaid in three years and two months) and she would save c. €833 in interest payments in the process.
Once the loan was repaid she would then save €303 per month and by year 10 she would have accumulated c. €27,295 assuming an annual return of 2%.
When you factor in the interest earned and the interest saved the monetary value would be €28,128 over 10 years.

Option 2 (Use Surplus Funds towards Saving– None to Debt)
If she continued to pay her loan at €203 for the next, five years’ and saved €100 into a savings account in parallel (years 1-5)and then when her loan was repaid in 5 years she could save €303 for the next five years (years 6-10), she’d end up with €25,408.
So, she’d be better off by €2,720 if she used her surplus money to pay off her debt first and then concentrate on her savings once it was.
As you can see, it was the same €303 per month that she was using, it’s just the outcome between both scenarios is different and whilst it’s not life changingly different it’s still better in her account than anyone else’s I say.
So, the answer to this woman’s question was clear and it was to pay down debt first with her extra €100 each month, but that won’t be the case for everyone because everyone will have a different set of circumstances which is why it’s important to factor them in while running the numbers in tandem so see which is the best route for you, along with factoring in things like existing savings, stability of income etc.

Liam Croke is MD of Harmonics Financial Ltd, based in Plassey. He can be contacted at liam@harmonics.ie or www.harmonics.ie