I think the question I have been asked most often by clients this year is: should I be saving money, or should I be paying off debt?
And of course, the answer is, unfortunately, like most things in life –there is not a simple answer.
Paying off debt is a rewarding thing to do, both for your pocket and for your peace of mind – but I always look under the bonnet at each person’s individual situation to work out which is a priority, and sometimes it is a combination of both.
Cost of running debt
The cost of running debt is much higher than the rewards you can receive from short term savings in the bank or building society at the moment.
For example, if you’re getting 2% interest on your savings but you also have debt on your credit card costing you around 18% interest per year, you’re much better off reducing the level of your debt.
But there was more to it in one of my client’s cases this week…
Lizzie (as we’ll call her here) and her husband have a mortgage of £150,000, credit card debt of £5,000, household income of £40,000, and nothing in short term savings.
They have some disposable income left every month, and were planning on paying it into the credit card to reduce the balance, and possibly to overpay on their mortgage to more quickly reduce the amount outstanding.
Disadvantages of paying off debt
What concerned me was that they had no emergency fund. While paying off a chunk of credit card every month or overpaying on the mortgage would obviously save money in interest – there are disadvantages:
- Sometimes credit card companies take the opportunity of reducing your credit limit when your outstanding debt goes down. This means that if an emergency arose, and you needed to pay for something on your credit card, you would be unable to.
- If you are trying to discipline yourself not to use your credit card at all, it’s not a good idea if your ‘flexible friend’ is your only access to emergency money.
- Again, allocating all your spare money to reducing your mortgage renders the funds inaccessible – as you cannot quickly get the money back out again, if at all.
The debt and savings balance
I suggested to Lizzie and her husband that they take a balanced approach. After a full budgeting exercise, where they agreed to allocate £x per month, we decided to do the following:
- Pay twice the minimum payment on the credit card.
- Give the credit card to a family member for safe keeping.
- Pay the remainder into a savings account to build up an emergency fund of three months’ salary.
- Once they had built up £7,000 in savings, start paying off the credit card with the full £x per month.
Rome wasn’t built in a day, but they left my office with a plan, knowing that in a couple of years they would have built up a financial safety cushion, and should be nearly credit card debt free. Most importantly, they are changing their habits!
Whilst the immediate thought may be that you should always pay off debt first, it really depends on the individual. You really need to look under the bonnet to be able to answer that one.
Henrietta Oxlade is an Independent Financial Planner with Radcliffe & Newlands and MyFamilyClub’s in-house finance sage! She has been advising individual clients since March 1988, which is why many of her clients consider her part of the family. If you want to contact Henrietta, email us on [email protected] and we’ll put you in touch.