Is it always better to pay off debt before saving?

It’s fair to say that being in debt is no fun, and paying it off, no matter the amount is a great feeling. The faster you can pay debt off, the less interest you’ll pay and the better off you’ll be.

But what if you want savings on the side for a new appliance, a holiday or emergencies? Are you better off paying down the debt completely before saving, or is there a smart way to do both and still end up on top?

As a general rule, paying off debt before saving is nearly always going to be the best option. While saving sounds good in theory, it all comes down to simple mathematics. When it comes to paying interest on debt versus receiving it on a savings account, paying interest on debt will almost always result in you having less money in your pocket in the long run. There are exceptions to this rule, and we’ll get to them later, but for now, here are a few tips on how to approach paying down debt.

Prioritise your debts

A good starting point is to take a close look at your debts and figure out which ones are costing you the most - start by knocking those off before putting money away in savings.

High interest debts such as credit cards (which can often be in excess of 20% interest) are the logical place to begin, but sometimes it’s simply too daunting to look at the entire thing at once. Try breaking it down into small, manageable chunks to get things under way.

Pay more than the monthly minimum

By simply paying slightly more than the minimum repayments on your debt, you can drastically reduce the amount of interest paid over time. Even if it’s a seemingly insignificant amount, it all helps over time. Often all it takes is sacrificing one luxury purchase per week to make this happen. You’ll need to get a clear picture of your needs versus wants to find the extra cash necessary to increase those repayments.

Long term gain

This approach to paying off debt pays dividends thanks to the way compound interest works. Take a home loan as an example - a $300,000 loan at 6.74% interest paid fortnightly at the minimum initial rate of around $893 will incur some $399,000 in interest over 30 years.

By upping that fortnightly payment to around $960, the loan will be paid off some 18 years sooner and you’ll save a whopping $156,000 in interest payments. We do these sums in greater detail on our website, click here to take a look.

This is a pretty extreme example, but it’s a great demonstration of how a small adjustment now can have serious benefits down the line.

Take some easy wins

Depending on how you’re wired, you may need some quick wins to get the debt repayment ball rolling. So if it helps your state of mind to pay off some smaller debts first (even though they may not be the most expensive), then by all means do it. It’s a similar approach to getting going with regular exercise. Even if it’s 20 minutes and you’re staggering along at snail’s pace, you’re still further along than someone who’s lying on their couch.

So are there exceptions to the rule?

Yes, but only if you’re disciplined enough to make it happen. If you’re able to transfer some or all of your interest bearing debt to a low interest or, better still, interest free option (a credit card balance transder, for example), then it could work to your advantage to put some savings into an interest bearing account. This way your cash earns interest for you, rather than your bank. Just be sure you use that extra money to pay off those debts before the interest free period runs out.

Should I have an emergency fund?

Some people recommend building an emergency saving fund to cover unexpected costs as they arise. While it may sound counterintuitive when you have interest bearing debt, it can save you having to resort to using the credit card to pay for these things. Once your emergency buffer reaches the desired point, make sure you start putting that money into the debt at that point.

When it comes to debt, everyone’s situations are different, however, as the Herald’s personal finance expert, Mary Holm, points out, “Avoiding having to pay for something is the equivalent to receiving money. Both improve your wealth.”

For more tips on paying off debt and avoiding it in the first place, check out this page on our website.

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Hi, I suggest there is another option to having some savings while still managing debt.  Using TotalMoney, I have funds set aside for future purchases.  But the kicker is that these funds are offsetting my debt so in effect I am paying loan interest on the net of these two amounts.

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Contributions to Kiwisaver or other retirement saving schemes should also be listed as exceptions.  In the example above, if the mortgage holder is not already a Kiwisaver member, they are likely to be better off in the long term using that extra mortgage payment to join and gain an employer contribution and the government tax credit.