To Save or Pay off Debt

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In a perfect world, we would all have more than enough money to satisfy our needs and wants, and we would never have to choose one thing over the other.

Like the spoilt three-year-old who stomps his foot and cries some crocodile tears, our desires would quickly turn into reality at the slightest sign of discomfort.

Unfortunately, by the time you hit five and you enter the doors of ‘big school’, you come around to the understanding that life just isn’t going to be that simple.

So it is when deciding whether to save or pay off debt. Both are extremely noble goals, and yet there isn’t always enough money in the bank to satisfy them at the same time. So which of these is the best road to take when resources will allow you to go in only one direction?

Well, as my Sixth Form economics teacher would say, “It depends”. I used to think that this was a clever escapist strategy, the answer to reach for when you really don’t have an answer. However, it turns out that she was absolutely right, in this, as in almost everything.

 

Paying Debt can trump Saving

Mathematically speaking, if you have credit card bills that are rising every month, and your interest rate is well into the double digits, foregoing paying the full, outstanding balance because you simply must stash away a ‘lil $1000 in case of an emergency might not be the most financially savvy thing to do. When you do this, what you are doing is choosing to pay approximately 20% in interest charges on your outstanding credit card balance for the sake of earning roughly two percent (if you are lucky) on the average savings account. This means you earn negative interest of 18% or you pay out much more than you earn over time.

This is the case with most forms of debt. The interest on consumer loans, student loans or even secured loans is usually higher than the interest you can earn on any deposit account. Of course that makes perfect sense because this is how the bank makes its money, by charging more to lend you money than they pay out on their deposits. It’s good to remember the old gambler’s rule here… “the house always wins”.

 

“Debt is a way of life for many people”

 

Even plunking more money into your mortgage might not be such a great idea. Lots of people argue with this because they say that it gives them a sense of security knowing that they have more equity, and the bank has less of a claim on their home, and, of course, there is also the savings in interest over the life of the loan. That’s fine, but you should also consider that there may be a cost attached to making pre-payments or penalties, and factor in the opportunity cost of using that money to invest in other instruments.

But does this mean that it is never smart to save as long as you have debts to pay? With car loans, consumer loans, credit cards and mortgages, debt is a way of life for many people, if not for everyone. It is a necessary evil, and as such you have to manage your finances in a way that allows you to save. You mightn’t be able to save constantly, but you should make timely top-ups to your account.

Before you think that I’ve gone completely mad, let me say there are instances when it’s better to save than to pay off debt.

 

When Saving should be a Priority

In the case of your mortgage, putting extra towards your principal could be a good idea if you qualify for an employer-funded mortgage assistance programme, and, therefore, your rate is unusually low. This means that the gap between potential gains on savings and investments and your debt interest is closer. So, the decision becomes negligible.

Additionally, if your choice of investment has good prospects for a favourable return and your debt interest is average, saving more would certainly be the way to go. Let’s say you can either get eight percent on a fixed deposit for one year or you can put this towards your debt, which has an interest rate of seven percent. Choosing to save means you make one percent on the spread.

The choice between saving and paying off debt is really more about balance than it is about finding an absolute equation though. Several non-mathematical factors come into play. The need to feel secure by having something saved for a rainy day. The necessity of contributing to an annuity plan, so you don’t need to depend on a government pension in your old age. The stability of paying off for your house, and owning it in full.

This is why I know that even after factoring in the mathematical calculations behind these decisions, many people will still act on emotion. My answer to that is… do whatever makes you sleep at night, but at least fully understand your choices.

 

 

Natalia Jones publishes dcaribbeanentrepreneur.com, which features business tips and news for upcoming entrepreneurs across the Caribbean.

 

Image credit: Istockphoto.com

 

Natalia Jones publishes dcaribbeanentrepreneur.com, which features business tips and news for upcoming entrepreneurs across the Caribbean.

1 Comment

  1. Sherwin

    June 14, 2010 at 1:51 am

    “…do whatever makes you sleep at night, but at least fully understand your choices.”

    My last job was at a credit union related company where I had opportunities to interact with the general membership of various credit unions. The man on the street generally does not have a good grasp of basic financial planning. I don’t expect most people to even know what all their choices are. They just borrow from a bank and know they have to pay x amount.

    As for employer-funded mortgage assistance programmes, do we have those here?

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