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.
Here’s the thing though: if you’re anything like most folks, your cheapest debt will carry a far higher rate than your most lucrative savings or investment. There are occasional exceptions such as “stoozing”, which involves taking loans or credit on a 0% deal and putting it in savings or investments until the deal ends. However, these require a lot of financial know-how and organization, and in any case they still only make sense if you have no debts whatsoever.
Human Nature Has Its Drawbacks
There are a couple of main reasons for this sin being so popular. The first is that we are always taught the value of saving. That’s fine in principle, but if you’re paying out more on debts than you make from deposits, the simple fact is that you aren’t saving, you’re wasting.
Yes, it’s good advice to have money set aside for a rainy day, but cash and savings isn’t always the way to do it. If you’ve hit your credit limit on a card, keeping cash is an expensive form of rainy day fund. Instead, pay off as much of your balance as you can. You’ll still have the same financial buffer, but this way you only need to pay for it when you actually need to use it. Of course, you will need the self-control to treat the unused portion of your credit limit as your rainy day fund rather than a way to fund non-emergency spending right now.
Secondly, there’s an understandable psychological flaw of paying off the smaller balances first because we like the “win” of wiping out a particular debt altogether. The problem is that if you adopt this strategy regardless of rates, it’s the financial companies that are the true winners.
The Ifs And Buts
There is one important exception to this principle: when tackling debts, you must take account of the consequences of non-payment. For secured debts such as mortgages and car loans, this can be much more severe than for unsecured debts such as credit cards. Whatever the interest rates, it makes no sense to take your monthly mortgage payment and use it to pay off your credit card. So before assigning spare cash to your debts, make sure you’ve made all the payments necessary to avoid negative consequences (other than interest) such as fees, penalties or forfeiture of assets.