Saving vs paying off debt: what’s better for your finances?

There are many benefits to saving. Financial security brings you peace of mind, and will help you to meet unexpected expenses head on. Savings also enable you to set and achieve long-term goals like going on a dream holiday or buying your first home.

However, is it sensible to save when you have outstanding debts? Or should your extra money go towards paying off what you owe? Discover what’s better for your finances in this guide to saving vs paying off debt.

4 things to consider when balancing your finances

Interest rates

Firstly, look at the interest rates on your loans and compare these to the interest rate of your savings account. Typically, debts have higher interest rates and therefore cost more than your savings earn.

Following this logic, it’s better to pay off your debts first otherwise you’ll be losing money in the long-run.

Repayment schedules

Next, consider the repayment schedules on the debts. Paying off loans in a timely manner is important as it will help to boost your credit score which gives you access to better interest rates in the future.

While making agreed repayments on time is vital, it’s not always beneficial to make overpayments to clear the debt faster. Trying to settle large loans like student finance too quickly can be a drain on your finances and leave you with insufficient spending money. Charges can be applied to overpayments for loans like mortgages, too.

As long as you’re keeping up with debt settlement, extra money can go towards your savings.

Different debt

It’s also important to understand the different kinds of debt.

Borrowing money to finance something that will benefit you in the long-term is thought of as ‘good debt’. This might be taking out a student loan for an advanced education course or buying a car for a job that involves driving.

Going into the red to buy short-term non-essentials such as a holiday, or equally getting behind on essential payments like energy bills, is seen as ‘bad debt’. This is because investing borrowed money in things that won’t grow in value or won’t benefit you financially shows a bad attitude to money management.

Emergency fund

‘Should I have an emergency fund?’ is a common question when it comes to balancing saving with paying off debts. Most experts recommend having savings equal to at least 3 months of your current salary, but does it make sense to keep this money when it could be used for outstanding payments?

The answer lies in the type of debt you are dealing with. Manageable ‘good debt’ with low interest and a solid repayment plan can be paid of slowly with no negative ramifications. In contrast, paying off unmanageable ‘bad debt’ will have knock-on positive benefits that make it worthwhile.

Bear in mind that if you use you spare funds to pay off outstanding debts, you may potentially need to turn to another credit card or loan in an emergency. However, with a blank slate and better credit score, you’re likely to get access to better interest rates.

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