Should you build up your savings or start paying off outstanding debts?

In December 2020, the average total debt per UK household stood at £60,860. On average, low-income families have around £95 in savings, while the high-income families have an average of £62,885. The gap between the two is becoming increasingly exacerbated by the effects of the COVID-19 pandemic.

Although building up a rainy-day reserve makes sense, it is possible that you’re paying more interest on your debts than you are earning on your savings, so building up your savings while you still have outstanding debts can mean you lose out.

The answer as to whether it is a good idea to use your savings to pay off your debts is not a straightforward one…

It is usually a good idea to clear the debts you owe as soon as possible; this will save money that would otherwise have been used to pay interest. Despite this, not everyone will be in the position to do so and there are some exceptions where using your savings to pay off debt may not be particularly cost-effective.

As a general rule of thumb, debts usually cost more than savings earn – therefore, cancelling them out can mean you are financially better off. As a result, paying off your debt is a better investment than saving.

The exceptions are in the few occasions when debts are cheaper than savings, or cost so much to pay off that it isn’t worth it …

The penalty exception: If you are locked into the debt, and therefore paying it off incurs a penalty, as with some loans or mortgages – then it is best to leave the cash sitting in a savings account until the penalty is small enough to not matter.

The interest-free/ very cheap debt exception: If, for instance, the interest rate on your debt is less than the amount your savings earn after tax, providing you are financially disciplined, you can profit from building up savings and keeping the debts. In effect, this will mean that you are being paid on money lent to you by the banks for nothing, e.g., on introductory 0% credit card offers or 0% overdrafts.

Unfortunately, many people will have much more debt than they have savings. So even if they were to use all their savings to pay them off, it is likely that they will still have debts left to pay.

Once your debts are as cheap as they can be, start by listing where they are and the amount of debt that you owe. Then, use some of your savings or spare cash to pay off the costliest debts first. All of this done simultaneously should help to massively reduce your costs.

If paying off your debts would leave you with little or no savings, you need to think about whether you'd be able to borrow at a cheaper rate than you're paying on your debts now

If so, then it could still be worth parting with your spare cash. However, you may want to keep some of your savings back if you are worried you might not get the credit you need in the future. Even if your savings don't cover all of your outstanding debt, it's still worth repaying however much you can.

Clearly, the option to use your savings to pay off debt is only a credible possibility if you have enough money set aside to help.

For many people, the idea of having some cash set aside in a savings pot will feel like a safe option. The jobs losses, redundancies and use of furlough that have come as a consequence of the pandemic have highlighted the importance of setting some cash aside to rely on as an ‘emergency cash fund’ – this is normally recommended to be between 3-6 months-worth of your income.

In summary, whether you should be using your savings to pay off debt really does depend on your circumstances. It depends on how much debt you owe, what type of debt you hold, how much savings you have, what it is that you’re saving for and where you have these savings.

Here at ilumoni, we want to encourage consumers to Borrow Well …

It is always important to have a wider budget plan and a plan for paying back the debts you owe. Inevitably, some debts are harder to control – and grow at a much quicker rate than others. For example, the more expensive forms of borrowing are taken on credit cards, overdrafts and payday loans.

Which is why, at ilumoni, we’re on a mission to make it easy for people to Borrow Well. We’ve been working to create an App that uses artificial intelligence, combining open banking, credit and eligibility data, to identify the simple things people can practically do to unlock better borrowing and start to Borrow Well.

If you are interested in hearing more about our app, register and we’ll keep you up to date with all of our latest developments.