It’s easy to feel pressured to have a savings account or some type of investment. Should I save money though or pay off debt? It’s so tricky to know.
Let’s have a look at some of the things to consider and how you could calculate the “right” answer. Having said that though, the peace of mind that comes with being debt-free cannot be under-estimated. And there is also a great case to be made to NOT pay your debt and in fact build an emergency fund first.
Many things to consider.
Interest Rate
Generally speaking (and almost always) the interest that you earn on savings is far less than what you would pay on debt.
As an example:
You bank account may give you 4 – 6% and fixed-term savings accounts may give you a bit more. Unit Trusts, ETFS or other investments will probably be even more (although not always after the fees have been deducted). But you get the picture, the earnings on your cash and investments is never as spectacular as the interest charged on debt.
Your debt, especially consumer debt, comes at a cost of 15% or more. Some personal loans and credit cards even charge over 20%! Now add to that the fees and admin costs and you are looking at a huge cost to you. This may sound a little “conspiracy theory like”, but store accounts are designed to trick you. They often offer 3 or 6 months interest free debt, but usually charge you “club fees” or other account fees. And the second you pass your interest-free period, they whack you with crazy high interest rates!
Thus, compare the interest that you would earn if you save your money versus the interest you are paying on your debt.
So if you’re wondering if I should save money or pay off debt, from this regard it is far wiser to pay your debt off.
Using your home loan as a savings account
If you have a home loan that you can access (pay extra into and withdraw when you need it) then you can save money by paying off your loan. If you pay extra into your loan account you will earn interest at the rate of your loan (currently in South Africa home loans are offered at around 12% interest). This is a good way to save for emergencies but at the same time you are paying off debt. See using your home loan account to save money for more info.
The Cost of Debt
Let’s look at a simple example of how much debt can cost you. If you have R1,000 and you put it in a savings account for 1 month with an interest rate of 4.5% you would earn R3.75 interest.
If you owe R1,000 on a loan and the monthly interest rate is 20% you would pay R16.66 in interest.
Thus, if you “save” your R1,000 for the month it is actually costing you money! You will have to pay R16.66 interest on your loan and yet you only earn R3.75 on your savings. You have to pay R12.92.
In this example, if you choose to save the extra money, it is actually costing you money and not saving at al! Do the interest calculations yourself in Excel.
Risk
Did you know that is most cases (if not all) the creditor (person or company you owe money to) can call up your debt at any time and insist that you pay it immediately. This is especially true for banks who can call up your home loan. This would put you in a terrible situation and could be disastrous to you and your family.
Debt always comes with a risk and therefore it is better to pay your debt as quickly as possible! Being in charge of your money means that you minimize risk by knowing and understanding the consequences of what you do.
Peace of Mind
Having debt causes stress. It’s not nice knowing that you owe someone money and especially if you are struggling to pay it. The consequence of not paying your debt can be dire and this all adds to your stress levels.
If you have the choice of saving R500 in your bank or paying debt off you should consider the peace of mind that you could “buy” yourself. Having no debt would be wonderful. You CAN get to that state by slowly planning, budgeting and working towards being debt-free this would bring great relief to life. See how to start unwinding the debt spiral.
So should I save money or pay off debt?
It is probably a good idea to have a small amount of savings that can be used for emergencies; but generally speaking it is far better to pay off debt rather than save. If you have any spare money at the end of the month work towards paying off your debt! This is why I am paying off my home loan early.
