Most people have lots of different goals when it comes to their finances - paying off debts, saving for a holiday and even thinking about retirement, all at the same time. With so many competing goals it can be hard to prioritise. We think paying off debt should be your number one priority, before you start thinking about building up savings or investing for your retirement.
When we talk about paying off debt first, we’re talking about ‘unsecured’ debts like credit cards, store cards and overdrafts and not mortgages or car loans which are referred to as ‘secured debt’ (because they are ‘secured’ against something such as your car or home).
Secured debts typically have lower interest rates because the lender is taking less risk. If you stop paying, they can repossess your home or car to cover the debt. Unsecured debts have higher charges and interest rates and will have a much bigger impact on your credit rating than secured debt. That’s why paying off unsecured debts should be your priority.
Debts like credit cards and store cards typically have high interest rates. Interest is what you pay a provider in exchange for them lending you money and is often how the lender makes their profit.
The longer you borrow money for, the more you will pay back in interest, so unsecured debts can become a huge drain on your money.
So, why should you pay off debt before saving money? We know that unsecured debts typically have high interest rates and the longer you borrow the money for, the more interest you will pay. Savings on the other hand have much lower interest rates and the money you make from savings isn’t as much as the interest you will pay on your debt, so it makes sense to pay off your debt before putting that money into savings. Let’s break this down…
If you have spent £500 on a credit card at 15% APR, that debt would cost you £75 a year. Now let’s say you were given a bonus at work and had some spare cash. If you had £500 spare, you could choose to pay off your unsecured debt or put your £500 into a savings account.
With a typical interest rate for a cash savings account being around 1%, after a year, you would have £505. So, saving your money would make you £5, but you would still owe an extra £75 on your credit card, so you would be better off financially to pay off your credit card before saving.
There are some types of unsecured debt that you might not want to pay off first. These usually come in the form of zero interest debt and debts that have high early repayment fees.
If you have a debt with no interest such as a 0% interest credit card, paying this off might not be your number one priority. However, these 0% interest periods are usually introductory, so it’s really important to be aware of when the introductory period ends and have a plan to pay your debt off before that happens.
Some lenders will include early repayment fees in their lending contract with you. That means they can charge you fees to pay your debt off earlier than agreed. These fees might mean your debt ends up costing you more if you pay it off early, so it can be better to continue making your repayments as planned.
We’ve written a blog about the steps you can take to help you clear debt. Click here [LINK] to get started on your journey.
Once your debt is clear, you can start planning for the future. We always recommend building emergency savings first. Emergency savings are a pot of money that’s easily accessed for unexpected events – like losing your job or your car breaking down. We recommend at least 3 month’s outgoings is kept in your emergency savings pot, but you can save more if you feel you need it. Once you have emergency savings in place, you’re in a great position to start planning for the long-term or saving up for that holiday!