Introduction
People have wildly different goals when it comes to their finances – paying off their debts, saving for a family holiday, and even early retirement. With so many goals, all of which are equally important, it can be difficult to prioritize them. Savings and holidays are important but it can be said that paying off your debt should be your biggest priority.
When we talk about paying off your debt first, we are talking specifically about the ‘unsecured’ debts such as credit cards, and personal loans and not mortgages or car loans which are the ‘secured debt.’ This is because secured debts usually have lower interest rates and if you don’t pay it off, lenders can repossess your house or car to cover the debt. Unsecured debts have higher interest rates and will have a bigger impact on your credit score which can affect any potential financing you would need in the future. Hence, paying off unsecured debts first should be your priority. It’s also important to keep your income-to-debt ratio in mind. Let’s dig a little deeper into this question that plagues millions across the world.
Why should you pay off your debt before saving?
Debts like store cards and credit cards usually have high-interest rates. So, the longer you borrow money, the more money you will pay in interest. They can drain your finances faster. It makes more sense to pay off your debt first and then focus on savings because if your monthly income isn’t high, then dividing that small amount will only weaken your financial situation. Here’s an example to add more context-
If you have racked up a £500 bill on a credit card at 15% APR, then that debt will cost you £75 a year. Hypothetically, if you were given a bonus at work, you could spare 500 dollars to pay off the credit card bill first instead of adding that 500 to your savings account first. This will ultimately help you save more the next month because a typical interest rate for a cash savings account is around 1%, after a month, you would have £505. But you would still have a debt of $75 on your credit card, so it’s a smarter financial decision to pay off your credit card first before saving.
Things to keep in mind while paying off your debts
- Zero interest debt
Zero-interest debts might seem like they should be low on your priority list while paying off debts but most of these have an introductory period on them. The zero-interest rule only applies for a certain time. So, it’s important to be aware of when the introductory period ends and pay it debt off before the offer ends.
- High repayment fees
Some lenders offer early repayment fees which means they can charge you for paying off your debt earlier than the agreed-upon date in the contract. These fees will end up costing you more if you pay them off early. For debts like these, stick to your contract’s repayment terms and conditions. Paying these off early will only hurt you financially.
When to make savings your priority
While on the subject of prioritizing paying off your debt, it’s important to acknowledge that there are some circumstances where you will have to prioritize savings. So here are some valid scenarios where you should focus on savings rather than reducing your debts:
- No emergency savings:
If you have no emergency savings then it’s valid to prioritize that over reducing your debt. Medical bills, home repairs, and emergencies are something you will never be able to predict. Building an emergency fund should be your priority in such cases. Being hit with an emergency medical crisis while paying off your debt with no savings would just be more disastrous financially.
- 401(k) plans:
If your company offers retirement savings plans, they may have an employer match. Try to contribute enough to get the maximum employer match which would essentially mean free money.
Conclusion
Managing your debts alongside savings can be like walking a tightrope. At some point, you will need to prioritize one. So should you choose to save first or pay off your debts as much as possible? While the answer will vary on a case-by-case basis, it’s important to strike a balance between the two. There are some cases where saving will take precedence, as we have highlighted above. But if you are in a financial position where you can reduce your debts first without hindering your essential monthly purchases, then you should prioritize debt repayment. We hope this helps clear up your confusion.