Savings vs. Debt

By | March 25, 2010

The battle between savings and debt is about more than whether you would rather enjoy yourself now, or save up for the future because since the Global Financial Crisis many people around the world weren’t given that choice at all. Instead families and individuals left without their main source of income when the breadwinner lost their job realised that in saving up for their future, the future is now.

People lost their jobs and faced financial hardship before the GFC, but the fact was brought to the forefront of our minds because for the first time, at the same time, we all knew someone or we were that someone, who had lost their job and were in danger of losing everything else. Thankfully we can all learn a lesson from such global financial crises and the lesson here is whether you are best suited to starting and building a healthy emergency savings fund, or whether you should pay down your debt.

Benefits of Starting a Savings Fund if You’re in Debt

It can be hard, and feel unnatural to be putting money away in a savings account when you know that you’re paying more in interest on a credit card than you’re earning in interest on your savings. But an emergency fund in this situation is not about the highest interest rate your savings can earn, it is about having funds available to keep on living and get back on your feet, without going backwards.

You may benefit from starting an emergency savings fund before paying off your debt if:

  • You have a savings account with a zero balance. If you have not savings and no emergency fund then you should start making regular contributions to a savings account while you make the minimum payments to your credit card. This not only makes sense if you are feeling insecure about your job, but it also means you have cash on hand for more short term emergencies like surprise school fees or urgent car repairs.
  • You have a significant amount of debt. If you have a high credit card balance, or a number of credit cards then it is likely to be awhile before your entire credit card debt is repaid. This means you will be going a long time without a financial safety net and only your personal budget can tell you how long that will be.
  • Your emergency fund covers all your expenses. An emergency fund should have enough money to cover between three and eight months of your living expenses and when you calculate your living expenses to know how much you need to save, your credit card repayments will be in those expenses. Therefore, with a savings fund, your credit card bills will keep getting paid. However, if you have paid off your credit cards in favour of starting a savings fund, and are using your credit cards as your savings fund you’ll just be getting back into debt.

Benefits of Repaying Your Debt With Your Savings

If you are the kind of person who can’t stand to have debt hanging over their head then you may channel the portion of your wages which would be destined for a savings account onto your credit card to repay your debt sooner. While it makes good financial sense to get out of your bad debt as soon as possible, it may only be the best option for your situation if:

  • You are secure in your job and situation. Perhaps you are self employed with strong clients or you simply know the company you work for is one which is able to profit from the GFC rather than go under with it and so you know that for the short to medium term at least that you won’t need three to eight months worth of living expenses saved up. Instead you can target your wages at reducing your credit card debt and have your money working to reduce the interest charges you’re paying, instead of sitting in a savings account where the interest earnings are not enough to break even.
  • You have a small savings fund. Even if you don’t have the full eight months of emergency expenses saved, you may have enough to cover ‘everyday emergencies’ which stops you from reverting back to using your credit card and allows you to focus on repaying your debt without adding new debt.
  • If you have the spare money, pay off your cards sooner and you can start a savings account too. if you repay your credit card debt then you can of course start a savings account too and your savings and your debt are no longer in competition – you can do both. For example, if you have a $5,000 credit card debt at 15% interest and your minimum monthly repayments are $100, you may have another $100 to spare each month. In putting that $100 into a savings account and repaying just the minimum on your card you pay off your credit card in 38 months and pay over $1,400 in interest. However, if you put both the minimum $100 and the spare $100 onto your credit card, you can pay it off in 31 months and you save almost $400 in interest; plus you can then put your old credit card repayment and your extra credit card repayment into a savings account and have the same savings in less time.

Being Financially Responsible vs Not

Whether you choose to pay down your debt in favour of a savings account or you focus on building a savings fund and pay only your minimum bills there are some general savings and credit card tips you should consider:

  • Just because you wish you had a savings fund a year ago doesn’t mean you should start one now. Hindsight is a wonderful thing and if you or someone you know was caught without an emergency fund when you lost your job in the GFC then you know the benefits of a savings account. However, you also know the benefits of reducing your debt and your monthly commitments and it is important to remember that the worst of the GFC has passed and in learning from your own and others’ mistakes you can be more financially responsible by living within your means rather than charging everything to your card.
  • You know yourself. Only you know whether you are the type of person who would feel more comfortable with a healthy savings account or a balance free credit card. Is it being in debt which keeps you up at night or is it living week to week without any spare savings? You only know whether paying off your credit card will give you license to accrue a new balance, or whether you’ll be able to cut it up, or pay the balance back to zero at the end of each month.
  • Live within your means. The savings vs debt debate is not only about how you will pay your bills if you lose your job, it is also about examining your spending and saving habits and making financially responsible changes. So many people got into so much trouble during the GFC because they were living outside of their means – whether that meant they weren’t saving or they were spending more than they earned on their credit cards, it was all about consumption. Instead, use the savings vs debt debate to decide how you can best avoid your own financial crisis and start living within your means for the present and the future.

This is a guest post by Alban from Best Credit Cards. Alban is a personal finance writer. He provides budgeting tips, and helps people to compare the best credit cards</a> online

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