Should I clear my debts before saving?
Financial planning can be a complicated process, especially as there are multiple ways of doing things and seemingly small sums of money can lead to huge gains – for example, putting just £88 a month into a pension from when your child is born until their 18th birthday could provide a fund worth over £1 million by the time they turn 65. So how do you decide whether to prioritise clearing debts or saving?
The general rule of thumb is to focus on whichever one has a higher interest rate. For example, if you have a debt with a 0% interest rate and a 4% return on savings or investments, then you may be better off prioritising saving and making the most of the higher returns – but only if you can clear the debt in full before you start getting charged interest.
However, it is usually debts that have the higher interest rates, which means it can be more effective to pay these down before starting to put money away. Although it may feel reassuring to see some surplus cash, your financial situation may not be healthier for it. Consider the following scenario:
Scenario 1: Build savings
- Save £170 per month for 5 years
- Interest rate is 1%
- After 5 years, you have saved £10,200 to the account and received £310.10 in interest
- Total: £10,510.10
Scenario 2: Pay off debt
- You owe £7,000
- Interest rate is 17%
- After 5 years, the accumulated interest would be £8,347.15 if no payments were made
- If you pay £170 per month, after 5 years you have paid a total of £10,200, reducing the overall interest to £3,200
The above demonstrates how much difference can be made to your total outgoings by prioritising debt: putting the money into a savings account would return £510.10 in interest, whereas paying the debt would save more than £5,000 in interest payments. Once it is out of the way, you can start adding the monthly payments to a rainy day fund. If you have multiple lines of credit, clearing the expensive ones first is usually the most efficient method.
Won’t my debts clear when I die?
Possibly, but not necessarily. When a person dies their estate becomes responsible for any financial obligation, and they are paid before beneficiaries. If you have an estate of £100,000 but debts of £120,000 then all of your assets will be used to clear them and your beneficiaries will not receive anything, while the remaining £20,000 outstanding dies with you.
As a result of recent pension changes, it’s possible to use pensions for financial planning. As they are held outside of an estate, they do not get used to pay creditors nor are they liable for inheritance tax.
Using pension release to clear debt
In some scenarios, it can be beneficial to use pension release to clear debts, especially for people who are struggling to make the monthly repayments. The following chart provides an example of how this can work:
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The details provided in this article are for general information only and are in no way deemed to be financial advice. All of the material is correct as of the publication date, but could be out-of-date by the time you read the article. For our latest information and news, please see our articles section: https://www.portafina.co.uk/whats-new
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