Once you finish college, get a stable job, find a place to live and start earning enough money a question inevitably comes up: “Should I start paying off my debts with the money that is left over every month or should I start saving up and then pay my debt once I have a substantial amount on my account?”. The short answer is that you should try and pay off as much of your debt before you start saving money. The long answer will include the “why” as well as the “what” you should do.
You see, it is all in the percentages that keep building up the amount of money you either have on your account or you owe. For instance, the money you have in the bank will have a very low interest rate, around 1%, while the interest rates on your debt can be anywhere between 5% and 21%, maybe even higher. So in the best case scenario, your debt is going to get bigger for about 4-5% every month, so when you get enough to finally pay off the original debt, the amount that you actually have to pay then will be much greater.
Profit for the bank
Another thing about banks is that yes, they are quite much into business and therefore aim for as huge profits as possible. And the major portion of profits for banks comes from your savings. The amount of money that you save with your bank is used to lend cash to other people or borrowers. The difference at which the bank borrows money from you and the borrowing rate it charges on other customers is their actual profit margin. In simpler words, it will always cost more to borrow money from the bank that what you would save.
Pay off your most expensive debts
Be sure you keep your credit cards after you have paid them off in full, you will have a relatively good credit rating if you occasionally buy something with them and then pay it off quickly afterward. You can also get an interest free deal on a card and pay it off before the interest free period runs out. This will help you in case something unexpected comes up and you have used up all your savings.
Use your savings
If you have some money in your account right now, you should consider using as much of it as you can part with to pay off those debts with the highest interest rate first of all. Therefore, you should take a look at your current debts, and mark the ones that cost you the most every year and focus on repaying them with the money you have saved – just leave enough money for your basic needs so you won’t have to take out another loan down the road.
There is something you should be aware of when trying to pay off your debt using your savings – not all debts can be cleared away efficiently using this method. For instance, certain types of mortgages will have actual penalties for paying before the set date. The best solution, in this case, is to take a part of your savings and put it into a different account that is specifically designated for the purpose of paying off the mortgage. The interest will keep building up and when the right time comes you can then use it to pay the debt. Be sure you are well informed about all the circumstances regarding your debt and read everything carefully before you sign.
Exceptions to the ‘paying-off-your-debts’ rule:
There are but very few occasions that can serve as an exception to this rule of paying off debts using your savings. For example-
- You can rule out the need to pay off your debts when the debts are cheaper than your savings. this basically means that if you feel that the cost of paying those debts are much higher than what you currently have in your savings account, then there is no point.
- Penalty exception: if you already have debts that are incurring a stipulated amount of penalty on you, such as mortgages and other exclusive loans, you can consider not paying them until the penalty amounts have reduced. You can leave the cash in your savings account until the penalty is small enough.
- Interest-free debt exception: This is specifically for those individuals who have constantly managed to pay off their debts so that they eventually become interest-free through prepayments. In such cases, if the interest rate on your debt is lower than the amount your saved cash earns after all tax deductions, you can easily earn from your savings and keep the debts as well.
The best is to make concerted efforts into paying your debts as quickly as possible. The sooner you pay off your debts, the happier and effortlessly you will be while managing your personal finances in the future. The advantages of paying off your debt first should be pretty obvious now – you will want to avoid letting the interest rate blow up and paying as much as you can right now.