Today I’m going to answer the age-old question: Should you continue saving or pay off debt first? I’ll go over the actual case study of a friend of mine by weighing up his scenario. I’ll use graphs to illustrate the overall outcome behind making minimal credit card repayments and saving versus paying it off immediately and adding the saved payments to your savings account instead.
Mr and Mrs X have a credit card with a balance owing of $2,000. The interest rate for their credit card is 17.5% per annum and the minimum repayment that they can make is $60 per month. They currently have $7,000 saved in a high-interest savings account that generates 2.25% interest. They are median-income earners and are taxed at 37.5%. The question they posed to me is:
Should we keep our savings untouched to generate interest or should we pay off the credit card debt with our savings ASAP? Here are the results:
By making the minimum repayment on their credit card, it will take 46 months to pay it off. During which, they will pay an additional $959 in credit card interest and fees or an additional $80.847 per month. If you’d like to apply this to your own circumstances, here is a link to a compound interest calculator:
MoneySmart – Compound Interest Calculator
After 46 months of leaving their savings account at $7,000 their $7,000 will be worth $6,842.72 after inflation factoring in the interest rate and rate of tax they pay on that interest.
From their $6,842.72 they will pay an additional $959 on interest and fees for their credit card. Meaning that their $6,842.72 savings will come at an additional cost of $959 resulting in a total amount saved of $5,883.72 or a 15.95% drop in the value of their initial $7,000.
Outcome: A Total Loss of 15.94% on Their Savings
If they put $2,000 of their savings towards completely paying off their credit card, their initial savings principal drops to $5,000. However, they have an additional $80.847 that they are saving per month on credit card interest and fees. Let’s see what contributing the amount that they would have spent on debt towards building their savings would result in over the same time period.
After 46 Months of contributing the amount saved on debt ($80.847) towards their savings, their $5,000 has grown to $8426.99. This reflects a 16.94% growth rate on their initial $7,000. This growth factors in giving up $2,000 of their initial savings principal to cover the debt.
Outcome: a Total Gain of 16.94% on Their Savings
As hard as it may be for some people to ‘give up’ their savings, it almost always makes more sense to use it to cover the high-interest debt. The reason being, that the negative interest from credit cards and loans will always significantly outweigh the positive interest from your savings account.
By holding onto their savings and making the minimum repayment on their credit card, Mr and Mrs X will lose 15.95% of the principal savings amount. This is due to paying credit card interest, principal payments, inflation and their marginal tax rate on savings account’s generated interest.
Alternatively, by withdrawing $2,000 of their original $7,000 savings and paying off the credit card balance immediately, they can save an additional $80.847 per month by avoiding credit card payments. If they simply put this figure into their savings account, they will generate a 16.94% profit on their initial savings principal.
Verdict: Pay off your Debt ASAP and you will save much more in the long run
The following are guides that I have written which cover some of the key concepts outlined in this article. They can be a great starting point for anyone looking to get started on their FIRE journey.