MAKING CENTS: Should I save money or use it to pay off debt?
Every little bit helps when it comes to savings
I received an email from an individual last week asking me whether she should try and accelerate the repayment of a loan she has or whether she should use what surplus funds she has each month to put into a savings account instead?
And it was a very good question and one that I’ve been asked many times’ before.
But how do you choose one over the other?
Should you focus exclusively on one or are you better off working on both at the same time?
And I’m going to give you my perspective in a moment but before I do, there is a very well-known financial type guru in the United States called, Dave Ramsey, and he says that once you have a small emergency fund in place ($1,000) you should focus all of your energy and any extra funds you have into paying off your debt, at the exclusion of every other area. He says don’t put money into savings or into your pension etc. use all of it to pay down high interest debt and once that’s’ done, then you concentrate on saving.
I like Ramsey and I like some of the things he says but I disagree with him in this instance.
And let me tell you why.
The longer you wait to start saving, particularly when it comes to putting money particularly into your pension, the more you have to set aside each month later on. Because when you start saving earlier you (a) get the benefit of compound interest on your savings and (b) you get the tax benefit of contributions and (c) you may depending on your circumstances get employer contributions as well.
These can be lost if you ignore saving at the expense of your debt.
But any decision and strategy you undertake really depends on your age and how long it will take you to repay your debt. If, for example it takes you 10 years to repay it and that brings you close to retirement age, then it’s really not a good scenario even if you end up paying more interest than you needed to.
Anyway, I wanted to crunch the numbers for the woman who contacted me to see if focusing on her debt was the best course of action.
Let me give you some background on her - she was 34, owed c. €10,000, her monthly repayment was €203 per month, the interest rate was 8% and there was 5 years left on her loan. In relation to her pension she was contributing 10% of her gross salary and her employer was contributing 12%. She had €3,000 in a savings account.
She had an extra €100 each month which she felt she could:
-Pay towards this loan and accelerate the repayment of it, or;
-Lodge into her existing 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 her savings account.
And you might think, why on earth would she consider saving money into an account that would earn less than 1% when she could be using it to repay a debt costing her 8%. And you’d be right, if, she had more savings in place but she didn’t.
If she had an emergency fund in place then it’s a no brainer. But she was shy about €7,000 from the amount I believe she needed to have.
Paying off debt with additional funds each month which is costing 8% means you are getting a guaranteed return of that amount and hard to beat that at the moment without taking risks.
And why would you need to take any risks?
But people are reluctant to use surplus savings to pay off debt and 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.
This can be a big mistake.
The only reason you shouldn’t use your savings to clear off debt is if you were clearing out your savings leaving you with nothing or very close to nothing left. If this was the case you would be unwise to do it, because you may need those emergency funds in the event of an illness or a redundancy etc. but if you have monies that are set aside assigned specifically to cover such eventualities, then I’d say use surplus monies to pay down debt.
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 open the account that is offering such a great rate. And of course this is not going to happen, but you can make it happen by using surplus funds to accelerate the repayment of any debt.
And the rate of return could be even higher particularly if you have credit card debt where rates can be as high as 20%. So, rather than thinking you are wasting your money clearing this debt off, I’d say think that you are getting an incredible return on your investment and you are making the possible use of your money.
Back to the lady who contacted me.
My initial thoughts were that she would be financially better off focusing on paying off her debt but I wanted to crunch the numbers first to make sure I was right. And I was going to look at the outcome of each strategy over a 5 year period.
Use Surplus Funds to Repay Debt – None towards Savings
If she overpaid by €100, her loan term would be reduced by 22 months and she would save c. €833 in interest payments.
She could then save €303 for 2 more years and over that time she’d earn c. €141 in interest so really the financial impact of this strategy were savings of €974 (€833 interest saved and €145 interest earned) and the balance in her account in 5 years’ time of €7,413, assuming an annual return of 2%.
Use Surplus Funds towards Saving– None to Debt
If she saved €100 over 5 years she’d earn c. €305 in interest.
But we know if this €100 was directed to overpaying her loan she’d save €833 in interest payments along with earning €141 in interest as well, so it was clear in this situation that paying off her debt had the bigger impact and if we were to put a number on it, it would be €669.
But perhaps that €669 saving over 5 years wasn’t enough for her and she was willing to save the money because she had very little in savings and seeing her savings account increase would give more peace of mind than paying less in interest payments which was unseen and not lodged to her account.
So, from a numbers point of view it was clear which was the best option. But even so, this women was going to have to hope that nothing was going to happen to her health or job over the next 60 months because if it did, in about 60 days’, she was going to be under severe pressure because her cash reserves would be exhausted.
I differ with Dave Ramsey’s advice because I believe having a small emergency fund in place is not a good strategy. How long would €1,000 last you? For some it wouldn’t last a couple of weeks and then what?
The answer to this woman’s question was to try and find a balance between saving and paying off debt. You try not to ignore either but sometimes one trumps the other and in her instance building up her emergency fund was more important than paying less in interest payments. But if she had that emergency fund in place (and I would recommend having three to four months’ salary in place) then I would have been telling her to go to town on clearing her debt.
Liam Croke is MD of Harmonics Financial Ltd, based in Plassey