Should I save or pay off my debts?

Should I save or pay off my debts?

Should I save or pay off my debts?

Knowing what to do with your money can be a difficult decision. Get to grips with the costs of saving vs. borrowing so you can make a well-informed decision on which is better for your financial wellbeing.

SAVING AND BORROWING: THE BASICS

The basic truth is banks want us to save and borrow. Banks use the money you put in savings accounts to lend to other customers but at a higher interest rate than your savings account.

This is ultimately (in very simple terms) how they make money; by charging borrowers higher interest than the savers.This means, even with a really good interest rate on your savings, the percentage charged on credit (loans, credit cards, overdrafts, etc.) will usually be higher.

Because of this, you could end up paying a lot more for your debts than you earn from your savings.

EXAMPLE: You have £200 on a credit card with a 35% interest rate and £200 in savings that earns 1.5% interest annually. The savings account will earn just £3 over the year but you will be charged £70 in interest on your credit card (if your balance stays the same), completely cancelling out the interest you earned on your savings.

In the above example, it is much more beneficial to pay off debts and then continue saving. If you’re unsure about whether you can spare any cash to use against your credit, why not try out our budget planner?

WHAT ABOUT EARLY REPAYMENT CHARGES?

Unsecured personal loans can often have fees for when you want to pay it off early or make overpayments. In this case, you should calculate if it’s worth the early repayment or if you would be better continuing with the original loan term.

If you contact your current credit provider, you may be able to negotiate on your early repayment settlement fee. Then compare how much you will be charged to close the credit compared to how much you would save on interest.

If it’s worth it financially, pay off your most expensive loan first as this will help you save the most amount of cash. Use our prioritising debts guide to find out more.

Example: £500 loan over 6 months at 99% annual interest rate. Total amount repayable would be £608.21. Charge for credit is £108.21.

Assuming the interest charged remains the same each month, you would pay £18.03 in interest per month and £83.34 towards the original loan amount (£500). This is a total monthly payment of £101.37.

Imagine you’ve paid two monthly repayments = £202.74. The remaining balance of the original loan amount is £333.20. If you used your savings to pay off your loan, you would save £72.12 in interest charges and be actively cuttind down your debt.

But, if your lender charged you £100 for paying early, it would be more beneficial to keep your loan account open.

WHAT ABOUT A FINANCIAL SAFETYNET?

We are constantly told to put a small amount aside each month in case of financial emergencies, like redundancies or unexpected bills. This is a great idea as borrowing money in a hurry can feel daunting.

However, saving for a financial safety net shouldn’t take priority over making your credit repayments on time and in full. If you can spare a couple of quid each month, it’s worth putting it in a separate bank account for emergencies. You can find out more about financial safety nets using our guide.

WILL PAYING MY LOAN EARLY HAVE A NEGATIVE AFFECT ON MY CREDIT SCORE?

The simple answer is no. If you have lots of different open credit accounts (i.e. a couple of credit cards, a personal loan and an overdraft) this can look unfavourable on your credit file. So in this case, it would actually improve your credit score by paying off your credit.

However, having an open credit account (e.g. a credit card) is more favourable on your credit score, providing you meet the repayments. Essentially, early repayments won't have a huge impact on your score so you should do what works out best for your financial wellbeing.

No idea what your credit score is? Get the lowdown with our credit file spot check guide.

This is because lenders want to see how good you are at managing credit right now so your current credit will have a bigger impact on your credit score. Your credit score is not the be all and end all though.

FINAL WORD

Using your savings on debts can feel like a waste of your hard earned cash but generally, it works out much cheaper. The Money Advice Service can help you work out if paying off your loan or making over payments is a suitable option for you.

USE OUR BUDGET PLANNER

Get started on your Take Control journey.