Why You Should Use Your Savings To Reduce Your Debt

We’re often criticised in the UK for not having a “savings culture” and not putting enough of our money away for a rainy day. Yet what I’m about to suggest might confuse you; I recommend that you use your savings to pay off your debt rather than leave them in the bank. Have I gone mad? No I haven’t and let me explain why.

Don’t keep it on the Down-low

At the moment interest rates are at an all-time low which means that the amount you earn on your savings is going to be very little. Yet the interest on a loan or credit card is always much higher. This means it makes sense to use whatever savings you have to reduce your debt. Let’s take an example: if you owe £1,000 on a credit card at 17% interest you’ll pay £170 in interest payments over the year. That same £1,000 in the bank may only be earning you 1.5% interest so you’ll get £15 a year. So, if you use the savings to pay off the card you’ll be £155 better off.

Banking in Short

Banks, basically, take savers money, give them interest on it and then lend it to other people at a higher rate. So if you have a savings account and a loan with the same bank you’re borrowing your own money and paying for the privilege. Silly, isn’t it?

Before you get too carried away and rush to draw out your life savings there are some exceptions to this rule: if you have a loan with an early repayment penalty period for example. In this case you might be better off waiting until the penalty period has ended or until it’s reduced to a smaller amount before you pay it off. Another exception is if you have interest free loans or credit cards, or low interest introductory deals. Here you can benefit by building up your savings and keeping the debt, paying it off when the interest free period comes to an end. The third exception is student loans where you don’t have to start repayment until you reach a certain earnings level. Once you do start to it pay back you have the option of making overpayments in order to reduce the debt more quickly if you’re in a position to do so.

Although mortgages have a much lower interest rate than other loans it’s still worth reducing the debt early if you can afford to and if there’s no penalty for doing so. The savings from this will be smaller but it’s still worth investigating. You might also look at deals like offsets where the interest on your savings or current account goes to reduce the amount you pay on your mortgage. This is a good way of getting more from your savings in the current climate of low interest rates on savings accounts.

But what about Emergencies

Many people feel they ought to have money available for a “rainy day” or to cope with emergencies. If you’re debt free then this is a good idea, but if you have expensive debts then it’s silly. The thing to do is pay off your debt with your savings and keep the credit card for emergencies. Let’s take another example: if you have £2,000 of credit card debt at 17% you’ll be paying £340 a year in interest. That same £2,000 in the bank at 2% will get you £40 a year. Pay off the debt and you’re £300 a year better off. If you then have to pay £2,000 for a new boiler, say, you can do it on your card so you’re no worse off than before. Except that the longer you go without a problem the more you’ll have saved.

If your debts are much bigger than your savings it’s still worth paying off what you can. You’ll then find it easier to manage the remainder either via a consolidation loan or some other method. The key is to deal with the debts that have highest interest first. You can do this by, for example, switching to a card with a lower interest rate and looking for balance transfer deals. When you’ve got all your debts on the lowest rates possible you can concentrate on paying off the most expensive first of that you maximise the benefit of reduced payments and increased savings in future.

Sarah Fox specialises in writing about debt advice and other financial issues for a variety of websites. Follow her advice and see your financial situation could improve.