Why you should use your savings to get you out of debt
Last Modified 16th of February 2021
Most people at one time or another will borrow money from a bank or a building society, whether in the form of a credit card, mortgage or personal loan. Did you know, however, that you could be needlessly in debt if you also have savings?
Paying off debt can sometimes seem like a struggle but you might be reluctant to use your ‘rainy day’ savings to meet payments. For some households that don’t have savings, this may seem like a strange scenario, however if you’ve built up a nest egg it’s perfectly understandable that you don’t want to dip into it to settle the outstanding balance on your credit card.
Banks use your savings as loans
In reality, using your savings to get you out of debt is both logical and advisable. Any form of credit arrangement with a bank or building society is funded by the money given to them by their savings customers – effectively money you’re entrusting to the bank is then used to lend to others; the interest you receive on that sum whilst it’s in savings is the benefit you receive from letting the bank loan it.
If you find yourself in debt then you owe money to the bank or building society with an interest payment included as a form of payment for their lending services. On the whole, the interest you accrue on debt is higher than the interest you receive on your savings, especially at times when the interest rates are extremely low. All this added together creates a situation in which your bank is creating a profit from you needlessly!
When not to use your savings to pay off your debt
There are a few scenarios, though, when this rule doesn’t apply. For instance, if you’ve made a repayment agreement with a lender and your contract includes a stiff penalty fee for paying your money back early, it’s probably not financially beneficial to settle that debt ahead of schedule. Similarly, debts with an extremely low interest rate – lower than the interest you receive on your savings – or interest-free debt can also be disregarded. These types of debts could include student loans and credit cards within a 0% interest free purchases promotion.
The best thing you can do for your long-term financial stability is to pay off your debts before you start saving any money. Getting back to a neutral financial state will reduce stress and worry, stop interest payments making your debt problems even greater and improve your credit card rating. Once you’ve restored your bank balance to zero, then you can think about avoiding future debt by building up your savings account.
The only thing worth thinking about in the debt repayments versus savings argument is ‘known payments’ that you will need to save up for – children’s birthdays, Christmas etc. In this case, putting a small amount away each month is beneficial because it’s for a specific purpose.
Clear the most expensive debts first
When it comes to tackling debts you should pay off your most expensive debts first – that’s the amount with the highest interest rate. Generally speaking, credit cards tend to charge more interest than other forms of borrowing. Once you’ve settled the most costly outstanding balance, use any remaining savings to repay the debt with the next highest interest rate and so on, until you find yourself debt free.
Use savings on your mortgage
Many people forget that mortgage is a debt and so disregard it when it comes to making overpayments. Although you might be reluctant to use your savings to reduce your mortgage, there are some benefits to doing this. Although in the majority of cases there will still be a large deficit to pay on the mortgage once you’ve made a payment from your savings, there will be less interest payable on the amount left because it is lower, which means you will pay off the remaining sum at a quicker rate.
With house prices falling during recent years, using savings to lower your mortgage debt is also handy if you bought your house with a small deposit and are danger of falling into negative equity. The less you owe the bank, the more money you could potentially gain if you choose to sell your house, even if the current value is less than you initially paid for it.
It might seem an emotional wrench not to have an emergency pot to fall back on, but once you see past this mental crux you may realise that paying off debts with your savings will make you better off financially in the long run. The sooner you can make yourself debt free, the quicker you can try and rebuild that nest egg to prevent you having to borrow money in the future if you’re hit by an unexpected financial obstacle.