I recently had the privilege to run a couple of webinars on ‘The Principles of Money Management’ for a group of young parents. At the end of each of these sessions, we had a wonderful period of question and answers that went for longer than the formal presentation itself did. There were a couple of recurring themes in the questions being asked so I thought it would be worthwhile sharing the answers I gave to these questions via a series of blog articles.
The first question I was asked by these young parents was:
“Is it better to save money or pay down debt?”
There is no simple one size fits all answer to this question because there are so many variable to consider but here are the points you need to consider:
1) You must always have a rainy day fund in place before you tackle your debt
One of the biggest mistake people make when trying to pay off debt is they throw all their surplus cash at their debt and leave themselves without any back up should an emergency or unexpected occur. Before you pay off any debt you must have a rainy day fund of at least $2,000 to $3,000 (preferably $5,000) tucked away in an offset or savings account – just in case.
2) Once you have a rainy day fund focus on paying off your high interest debt
Now I know when people are asking about whether they should save or pay off debt they are more thinking about their home loan debt not high interest lifestyle debt, but I just need to be sure. If you do have credit card debt, personal loans, car loans or interest free loans there is no question that this high interest debt must be paid off before you consider saving money.
3) Before you tackle your home loan you should grow your rainy day fund into a cash reserve
Okay – so assuming you have paid off your high interest debt and all that remains is your home loan, your next priority is to turn your ‘rainy day fund’ into a decent cash reserve that equates to 3 months’ worth of your budgeted expenses. For most people this means having $15,000 – $20,000 tucked away in a high interest savings or offset account. This sort of reserve ensures you have decent back up should something really nasty happen – such as unexpected family illness, injury or loss of work.
4) Now do we save or pay off the home loan?
With the lifestyle debt gone and a decent cash reserve in place what next – do we save for the future or pay off the home loan?
With interest rates so low it is understandable to question whether saving is better than paying off the home loan, however if you are in your 20’s, 30’s or 40’s you are almost always better off paying down your home loan than simply just saving for the future. Here are my reasons why:
– One dollar paid off is one dollar you won’t have to pay interest on tomorrow. Paying off your home loan offers a predictable and consistent outcome, unlike investments you do know the outcome and every dollar extra you pay off your home loan brings you one dollar closer to debt free.
– Interest rates won’t stay low forever. You can be absolutely certain that interest rates won’t stay this low forever. The 50 year average variable rate for home loans in Australia is 8.6%. I don’t believe we will see 8% any time soon but interest rates will rise – so make the most of this low interest rate environment to knock over your loan extra fast.
– With focus most people can knock off their home loans in less than 15 years. I often come across people who are worried that they won’t have enough time to both pay off the home loan and save for retirement (or the kids’ education). However the reality is most average mortgages can be paid off inside 15 years by making a concerted effort to pay double the principal payment required each month. On a 30 year, $350,000 home loan @ 5% interest the repayment is $1878.88, of which just $420.55 is principle in month one year one. If you focused on doubling this principal payment each month you would have the loan paid off in 15 years and in the process will have saved yourself $178,000 in interest. Then imagine how much you could save with the $2,800 + you had previously put towards your mortgage.
– Being debt-free provides you with life opportunities. While we can make smart calculations and assumptions about whether it is better to pay off debt or save money, one subjective yet very powerful factor that often gets overlooked is the freedom that comes from being debt-free. People’s lives change in a tangible way when they are no longer tied to a mortgage; they suddenly find themselves free to take a lower paying job that they actually enjoy, to start that business they have been dreaming of, or to work a little less and travel a little more. Having savings is nice but it cannot replace being debt-free.
5) But what about big lifestyle expenses like school fees or replacing the car?
If you are worried about saving for bigger lifestyle expenses like the kids’ education or a new car, channeling all of your savings into an offset account instead of your mortgage can provide an excellent compromise. An offset account is a bank account that sits alongside your mortgage – any money in that offset account is considered as paid off the mortgage and therefore saves you interest. So if you have a $200,000 mortgage and have an offset account with $100,000 in savings you only pay interest on $100,000. You can set up an offset account for school fees for instance and while that money is accumulating ready to pay school fees it will be saving you significant interest on your mortgage.
You can probably tell that I am a big fan of paying off debt. Personal experience and the experience of my clients has taught me that working towards being debt-free as opposed to savings offers far greater rewards. With single minded focus toward achieving ‘debt-free’ you will ultimately come out in front both financially and from a perspective of personal fulfillment.