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Paying off debt vs saving money

Paying off debt vs saving money

So, you’ve got some extra cash up your sleeve or maybe you’re looking to free up some cash from your payslip.

11 August 2020 · 3 min read

So you’ve got some extra cash up your sleeve or maybe you’re looking to free up some cash from your payslip. Like the chicken and the egg, what comes first? Should paying off debt be the priority, or is saving more savvy?

There are two schools of thought.

One strives to be #debtfree as soon as possible, while the other reckons saving your hard earned is the best bet. Allowing yourself to do both at the same time is important, but sometimes you need to make a choice between one or the other. What’s the best use of your money?

Saving season

Saving money allows you to put all your cash away for a purpose. Save for a house. Save for a rainy day. Save for a Europe trip in 2020. Saving is versatile and gives you that little buzz every time you see an extra 0 at the end of your balance.

Having a savings account that is growing is awesome, but ​actually​ growing your savings has become increasingly difficult in recent years.

Interest rates on savings accounts in Australia are at all-time lows, in-part due to the low cash rate set by the RBA (currently the lowest it's ever been at 0.75%). For a saver, getting a return above 2% is now considered decent.

This means your savings could increase around 2% each year. This compounds year on year, but compared to current interest rates on credit cards (which are usually between 15% and 25% per year), there is a sizeable difference in how quickly savings will grow versus debt.

Credit card repayments

If you have a credit card, check the bottom of the first page of your statement. This should contain your ​minimum ​repayment amount (usually 2% of the amount owing).

Paying the minimum repayment only means you avoid late fees. This amount doesn’t mean you’re paying your credit card debt off in full, so any amount still owing will accrue at the (usually high) interest rate.

For a $2,000 debt with 15% interest, the minimum monthly repayment at 2% would be $40. It would take 14 years (and nearly $2,200 in interest) paying off the loan versus 2.5 years (and around $400 interest) if they were to pay twice this amount ($80) per month.

Have a play with ASIC MoneySmart’s credit card calculator to see how long it would take to pay off your credit card with only the minimum repayments versus putting a bit extra in.

Not all debt is equal

You’ve probably heard someone say HECS is the “cheapest debt you’ll ever have”.

Debt comes in many shapes and sizes, but doesn’t always carry an eye-watering interest rate. If you’ve undertaken tertiary education in Australia, one of the first large debts you may owe is HECS debt.

HECS (or HELP) debt is money you owe the government. The advantage of this debt is the government indexes interest with CPI (the Consumer Price Index, a ‘basket’ of goods and services used as a measure of inflation), meaning interest on student loans in Australia hasn’t been above 2.5% since 2014 (in 2018 it was 1.9%). Also, you’ll only start repaying some of your loan if you’re earning over $45,881 (for FY19-20).

HECS debt is designed to be paid off over a longer period of time. Other debts with higher interest rates are best paid off ASAP and can affect your credit score if not paid off on time.

Crunching the numbers

In the end, paying down debt first gives you best bang for your buck, while saving will give you peace of mind as well as some equity on the side to draw on if you need.                                                                    

If you have multiple debts to pay down, think about whether you want to pay the lowest balance first and get some quick wins, or if you tackle the account with the highest interest rate.

Check what rate of interest you are paying (or earning) and remember there is no harm in reaching out to see if you can negotiate a better deal.                                                                  

The information in this article is prepared by Spaceship Capital Limited (ABN 67 621 011 649, AFSL 501605). It is general in nature as it has been prepared without taking account of your objectives, financial situation or needs.

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