Like most things when it comes to money when deciding whether to pay off debt or save first, it will depend on your personal circumstances and what the debt relates to.
Although, it’s fair to say it’s usually far better to pay off debt first.
Why? Simply that that the interest you will receive on money you save will be subject to tax, and the after tax amount will nearly always be lower than the cost of the interest you are being charged on your debt. It’s what they call the opportunity cost.
A basic savings account will attract interest of around 2.7%, which after tax assuming your tax rate is 30%, will mean you retain about 1.9%. Compare this to home loan rates of say 4.9% and you can immediately see that you would be about 3% better off by paying down your home loan debt rather than putting the money into a savings account.
When it comes to home loans, this is usually best achieved by way of utilising a tax offset account.
Many home loans come with this feature that allows you to deposit money into this type of account that reduces the interest that you would otherwise have to pay on your loan. You are then also able to redraw from the account when the need arises, such as for renovations or other family expenditure.
Of course when you then look at credit cards where interest rates can be 19% or more, it really is a no brainer that you simply must pay off credit card debt before starting a savings plan.
If you decide to save and instead paying down your credit card debt psychologically, you might think you are getting ahead but the money you are ”saving” will growing at a much slower rate than your debt.
Take the example of $10,000 in credit card debt. Ignoring minimum repayments, at 19% you will have incurred $1,900 in interest in one year, yet at the same time using the savings rate of 1.9% after tax, you will have saved only $190 over the same period.
The exception to this thinking might be balance transfer deals where you can shift your debt to a lower cost card with the idea that you will pay it off quickly. Some balance transfer deals mean you will pay low or even no interest for a period of six months or more.
This can be a big saver, but it only works where you use the interest free or low interest period to pay down the debt; so it does require financial discipline. Worst case you can end up with effectively two cards and even more debt which is double the trouble!
The decision when it comes to credit card debt is an easy one.
Whilst the maths works out the same way, but the benefit gap is much smaller when it comes to home loans, the same is not always the case when it comes to debt related to investments which is tax deductible.
Borrowing money to invest in income and or capital growth assets, the most common example being negatively geared property, can work very well as you are able to claim a tax deduction for the interest charges against your other income.
As I’ve said before, this can be a sound investment strategy, but you still must be able to afford the negative cash flow of any after tax net rental loss and you must still get sufficient capital gain over time to cover these accumulates losses and then provide a reasonable return on your investment.
So putting money into a savings account and not paying down tax deductible debts can work, but not when you have a home loan as then it should be the focus of your debt reduction strategy, as remember that you cannot claim a tax deduction for interest on the property you are living in.
In short it is nearly always in your interest to pay down your non tax deductible debt before starting a savings plan, but as always, every person’s circumstances are different so do seek professional financial advice that takes into account not just where you are at now financially but also your personal and family’s goals and aspirations.
For more information visit www.bellpartners.com
