Building up your savings can be rewarding, but you could be damaging your finances if you have outstanding debts. Here's how to work out whether you should use your savings to clear money you owe instead.
While it makes sense to build up a rainy day fund, doing so while you still owe money elsewhere could be costing you dear.
Here are the pros and cons of using your savings to pay off your debts:
It's likely you are paying more interest on your debts than you are earning on your savings - this is, after all, one of the ways banks make their money.
As a result, building up your savings while you still having outstanding debts can mean you lose out as you may end up having to repay more than if you'd cleared them straight away.
Consider that a credit card that charges 15.9% APR and has an outstanding balance of £10,000 would cost you £1,590 a year in interest.
When you compare this to even the most generous of savings accounts at 5% AER, which would earn £511.62 of interest a year on the same £10,000 balance, you're still making a loss of over £1,000.
Paying off your debts is also tax efficient. The sums above assume that you have your savings in a tax-free account, like a Cash ISA. If your money is in a standard savings account you'd pay tax on the interest you earn so you'd lose out even more.
What's more, if you hold your savings and your debts with the same bank, you could in effect be funding your own borrowing. This is because the bank are likely to be paying you a lower rate of interest on your savings than they're charging on your debts - you lose out, and they make a profit.
Consequently, looking at using your savings to repay any debts that you're paying interest on is a must.
Expensive debts, such as those on high interest credit cards or payday loans can accrue interest at a staggering rate, making a mockery of any return from a savings account.
So, if you have several different debts outstanding, repaying the most expensive first will be the most financially beneficial.
Equally, only making the minimum repayment each month, while trying to save, means it will take you much longer to be debt free.
Remember if you can clear your debts sooner rather than later, you will then have more spare money left over which you can use to save.
In the most cases clearing your debts before starting to save will make your money go further, however in certain circumstances this may not be the case, here are some of the exceptions.
Firstly you will need to check that the cost of your debt is greater than the reward from your savings.
Do this by listing all of your outstanding debts along with how much you owe and how much you're paying in interest. You should also note down whether you're able to repay the debt now without being charged early repayment fees.
Next, list any savings account you have money in, the balance and how much interest you're earning after tax - you need to look for the 'net' (after tax) figure as opposed to the 'gross' (before tax) figure. You should also note down whether you're able to withdraw your money now without being penalised.
Identify which debts have higher interest rates than you're earning on your savings. While the majority of debts are likely to be more expensive, if you have money outstanding on an interest free overdraft or on a 0% balance transfer credit card this may not be the case.
Consider using your savings to clear as much of your 'expensive' outstanding debt as possible - providing you won't be charged for doing so.
This may also be the case with your mortgage, and although you could class your mortgage as just another debt there are certain differences.
Firstly, like a loan, there may be penalties written into your T's and C's for paying extra off your balance.
Secondly, unlike other forms of borrowing a mortgage doesn't represent an easily accessible form of credit; meaning once you've over paid you may not be able to borrow back the money if you needed to.
Read our article Should I Use My Savings to Pay Off My Mortgage? to find out more about your options.
Before you use your savings to clear your debts you need to consider whether you will need to use the money in the near future.
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, if you are worried you might not get the credit you need in the future you may want to keep some of your savings back just in case.
Read our guide for more options if you are concerned about how you'd cope should an unexpected bill crop up.
Even if your savings don't cover all your outstanding debt, it's still worth repaying however much you can.
It's a good idea to use your savings to pay off your most expensive debts first as these will be costing you most in interest now.
However, once some of your debts are paid off avoid the temptation to splurge the money you have spare. Instead, keep on repaying the same amount (more if possible) so that the rest of your debt is cleared at a faster rate.