Ask people what’s the worst thing they can do with their personal finances and you’ll get a whole range of answers: spending frivolously; keeping cash under the mattress; paying back only the minimum payment on cards.
But as bad as all of these can be, there’s one thing that can be dumber than all of them: yet far too many of us do it right now.
The Crime Defined
What’s the sin? Simply put: having savings and debt at the same time.
Here’s a very simple example of why it’s so wrong in principle. If you have a £1,000 credit card balance at 18% annual interest, and £500 in a savings account at 5% annual interest, then at the end of the year you’ve paid £180 in interest, made £25 in interest, and wound up £155 worse off.
If, however, you use the £500 in the savings account to pay off some of the card balance, you wind up paying just £90 in interest. You’re still paying out overall, but you’ve cut your losses by £65.
Not only is this hypothetical example a reality for many people, but some of us even have debts and savings with the same financial institution. That’s absolutely crazy. There’s a good reason banks charge more in interest on debts than they pay in interest on savings: it’s how they turn a profit. When the banks can exploit this rate gap with the same customer, they must be secretly laughing their heads off.
What’s The Answer?
The key to overcoming this financial sin actually lies with a wider principle: prioritizing the debts with the highest interest rate. All things being equal, you should always put any spare cash towards paying off the highest rated debt, for the simple fact that it cuts your overall interest costs. Remember that every penny you pay in interest is effectively a complete waste of your cash. Paying the highest rated debt first means more of your money is working for you.
Extending this philosophy to take account of savings is fairly simple. Every one percent you earn in interest or investments is equivalent to using the same cash to pay off one percent in debt interest. Using cash to earn interest at 5%, like in our example, brings only the same benefit as paying off a debt that carries a 5% rate. Continue reading