If you have more money at the end of the month, then you have to decide what to do with the extra. If you’re carrying any sort of debt, then you basically have three options, pay it down, save or invest. Let’s look at what this means in practice.
The pros and cons of paying down debt early
You’re going to have to pay off your debt at some point, so the question is really whether or not you should take steps to try to pay it off early. For the most part, the answer to this is likely to be yes, but there are a few (possible) exceptions.
- If you have no savings at all
- If you have 0% interest debt you can pay off before the deal ends
- If you have student loans
- If there are penalties for early repayment
- If you can actually get a better deal elsewhere
If you have no savings at all, then it’s best to put together an emergency “cash cushion” before you start paying down debt. You might also want to see if you need to increase your insurance cover since you will presumably want to limit your exposure to unexpected expenses.
If you have 0%-interest debt and you are confident that you can pay it off before the deal ends, then financially you gain nothing by paying it off, so you might as well build up your savings/investment and get some kind of return. If nothing else, you could use your savings to pay off your debt later if the need arises.
The last three are numbers games and you’ll need to do your own calculations based on your own circumstances. Be aware, however, that interest rates can go up as well as down, so if it’s a finely-balanced decision, then you should think very seriously about how much risk you are prepared to take.
The pros and cons of saving and investing
Saving, and especially investing, is how you make your money grow. This means that, in principle, there should only be an upside to it. In practice, however, saving and, even more so investing, only works if you are sure you have the money to spare. With investing, not only do you not get a guaranteed return, but you will probably find yourself being charged for making any changes to your holding and there are also likely to be tax implications, especially if you have dividend income or sell shares for a profit.
In short, debt repayments are a must, as is the interest on them, whereas the returns on savings and investments are a maybe. It can therefore be both expensive and risky to put money towards savings and investments instead of paying down debt.
Strategically paying down debt
There are a couple of approaches you can use to pay down debt strategically. The classic “snowballing” approach is to start with the highest-interest debt and focus all your spare money on that. Once this is cleared, you move on to the next highest-interest debt and so on. This strategy aims to minimize the amount of interest you pay and hence maximize the amount of money which goes towards repaying the underlying debt.
There is a twist on snowballing, which can apply to people who have “spotty” debts. For example, if you’ve opened up lots of credit/store cards possibly to get special offers and have small balances on them. In this case, you could focus on paying those balances off in full and then closing the account. This can make your credit rating look much healthier and at least lay the groundwork for later balance transfers, even if you still have to do some work on reducing your debt in general before you stand a realistic chance of being accepted for them.
If you need debt advice please contact us.