Saturday, 25 October 2014

When is it ok to use my savings to clear debt?

Is it OK for me to stop saving and pay off my debt?

That is a question that I see being asked quite a lot around forums and blogs about money. So to clarify the situation, the answer, here at the Smart Wallet HQ is an unequivocal and absolute YES. Get rid of any savings and pay off your debts. Go. Do it now, I'll wait until you return.

I can say this with certainty, because you stand to save more by doing this. Stop right there, first I'm told that saving is the key to good finances, and now that I have some savings you want me to stop saving and use it? Yes. Debts cost more than savings, clear it off and your finances are better off.

Lets get some things cleared. A credit is a positive addition to your net worth, like when my business pays me at the end of the month. I now have a net credit worthiness of say £2000, which means that I am now worth £2000 more than I was, 24 hours earlier.

A debt is the opposite of credit, in fact it is negative credit. If I have a debt of £1000, I am now worth £1000 less, because sooner or later, I will have to pay that money back. It is easy to calculate your net worth this way. Just add up all of your positive credits (house, car, laptop, jewelry) and then subtract all of your negative credits (credit card balances, loans, mortgages). Your OK when the sum is positive, but when it is not, then you need to start rethinking your finances.

The problem compounds because of, well... compound interest. Your £1000 negative credit can easily spiral to several times that. (Assuming a 35% APR on a credit card balance of £1000, after 1 month it will be £1029, after 2 months £1159, and after 12 months £1411).

And to add to our woes, the credit lenders are like casinos, the house always win. The debt interest rate will always beat any savings rate they provide. So if you borrow £1000, and put it into a savings account - you will lose. The savings will be paltry, compared to what you have to pay back in interest.

Ok, lets crunch some numbers. Lets assume you have a debt of £10000, with a modest 15% APR. This could be a car on finance or a personal unsecured loan. And lets say you have savings of £5000 earning 5% interest (yeah, right - that's not very easy to get, most banks pay you peanuts on your savings).

So your net worth is £5000 (without calculating for next months salary), and assuming no extra income/outgoings, your net worth is going to be as shown in the table below.

The only winning move is not to play.
-ve Credits +ve Credits Total
Current Month -10,000 +5,000 -5,000
Month 2 -10,125 +5,020 -5,105
Month 3 -10,251 +5,041 -5,210
Month 4 -10,379 +5,062 -5,317

As you can see it is a fools game. You cannot win. Your savings will never outweigh your debts. And your net worth is spiraling further and further into the negative.

Now assuming that you use your savings to pay off the debt, here is another simulation:
-ve Credits +ve Credits Total
Current Month -10,000 +5,000 -5,000
Month 2 -5,062 +0 -5,062
Month 3 -5,125 +0 -5,125
Month 4 -5,189 +0 -5,189

There is some light at the end of the tunnel, your net worth is a lot better in this scenario than in the previous one. Just after 4 months, your £128 better off than if you left your money in savings. 

So, there you have it. While my theoretical simulations above may not represent your current financial circumstances accurately, it should give you a base for doing your own napkin calculations (if your inclined that way, I would recommend a good free spreadsheet, like google docs). Your always guaranteed to save more for your future self by paying down debts now.

There are specific cases, like my pre-2012 student loan, that incurs 0.0145% interest, which is beaten by my 0.018% savings in my emergency fund.

There are certain factors to take into account, the first and foremost is to pay off the most expensive debt first. This will be payday loans (why you have those is beyond me!), store cards (again, why?!), credit cards (a bit better, but still shop around for good deals, and money making schemes), as opposed to the mortgage, or a student load or a cheap personal loan - which provide 'cheaper' interest rates.

Consideration should also be given to a consolidation of loans. This will generally require speaking to someone face to face or over the phone, but it might help to reduce your costs and repayments (and credit score) by having to make a single repayment instead of 3 or more per month. You might also be able to use credit cards to your advantage, by shifting the balances of several cards to a long 0% deal. Sometimes, just asking politely, you might get a reduction of the rates on your debts too.

Thirdly, look out for the small print. Common sense would dictate, that a lender would be happy to accept early repayment, as they are getting their money back and can use it elsewhere. But no, despite the fancy 3 piece suit your banker wears, he only does it to hide his dorsal fins and other shark like traits. There are a whole host of fees and penalties that a lender can charge you for early repayment. And in some cases, this might be the same as the interest they expect you to incur over the loan term, so you might be better off in that scenario, saving your money and slugging off the repayments as expected. Some mortgages, do allow a small percentage of penalty free over payment per year - if you can do that, do it.

Finally, don't forget to keep an accessible liquid emergency cash fund. Life can throw anything at you at anytime, from a burst drainage pipe to a broken boiler. It makes sense to pay off expensive loans/debts and should you need emergency cash, you can reborrow on a credit card and pay off the card within 30 days - but if getting a credit card is difficult or the rates are horrendous or you need the cash for longer than the 30 days interest free period, an emergency cash fund is important. For example, a cheap mortgage might mean you can use all your savings to overpay, but keep £1000 for emergencies. Or you might choose to spend all your savings overpaying the mortgage, knowing that you have a few thousand £ limit on a credit card. But should you have a 35% APR credit card loan, throw all your savings at that, and you can always reborrow from the card later should you need to. This will vary based on your circumstances, so will require some thought on your part.

That concludes my thoughts on debts vs savings. I hope that this piece encourages you to think about where your money will make the most impact (paying off debts), and hopefully it saves you some money in the long run too. Adios. 

Wednesday, 1 October 2014

Word of the Day: Acquiescence

noun: acquiescence; plural noun: acquiescences
  1. the reluctant acceptance of something without protest.
    "in silent acquiescence, she rose to her feet"

  2. synonyms: permit, consent to, agree to, allow, assent to, give one's consent to,accept, concur with, give one's assent to, give one's blessing to, say yes to, give the nod to, give one's approval to;

  3. antonyms: forbid, refusal