On repaying debt before saving

cryozot

EDIT: I'm sorry I decided to mask the numbers, as I feel it's a bit sensitive information

Dear All,

This seems to be a common question, but all I could read on that matter contradicts my own conclusions which I've arrived to after doing some research. Perhaps my situation is different and this is sensible, but I thought it's better asking the board as well just in case I'm missing something.

My situation is as follows:
1) I'm saving for mortgage deposit, going to the first time buyer in two years time -- that's my time horizon
2) I have circa XXXX of debt
3) Of that sum, XXXX is an outstanding amount on a bigger fixed term loan with 4.3% interest. I'm paying XXXX a month
4) The rest of the debt (XXXX) is on interest-free credt card with 2.5% minimum monthly payment, that's going to be circa XXXX in June. The deal is going to go until Oct'15, after which I need to shift the outstanding balance to another similar card
5) I have XXXX in cash and I could repay all debt tomorrow

The question is, should I do that or I'm better off keeping that money in savings. Despite the fact that most people recommend repaying any debt before saving, my own math shows that I'd be better off by not repaying early and holding on to cash.

Now, the math itself. On the one hand, I can invest XXXX for two years under 5% with P2P lending (that's Zopa's current rate), or 2.7% with a more traditional and FSCA-backed facility like Sandander's interest paying current account. Given conservative 2.7% interest it's going to be XXXX in two years time. By the same my outstanding debt is going to be circa XXXX. If I clear all outstanding debt before applying for mortgage, I will have XXXX left.

On the other hand, I can repay all debt tomorrow and instead save exactly the same amount I would have been paying each month. I couldn't use P2P in that case, but 2.7% Sandander's deal is still going to work for me. After 24 months is going to be circa XXXX debt-free.

What is tells me is that I'm going to be almost £700 better off if I don't repay the debt, but keep on holding onto cash instead. This is somewhat confusing, as it is the opposite of what the 'common sense' advice is about, i.e. repay all debt before saving. I wonder if I'm missing something or it is the case of being in a situation which the advice does no apply to?

Averaged

cryozot wrote: »

What is tells me is that I'm going to be almost £700 better off if I don't repay the debt, but keep on holding onto cash instead. This is somewhat confusing, as it is the opposite of what the 'common sense' advice is about, i.e. repay all debt before saving. I wonder if I'm missing something or it is the case of being in a situation which the advice does no apply to?

Your maths looks likely to be wrong to me - if you're paying 4.3% on the loan then you can't do better saving at 2.7%, and (assuming you are a taxpayer) you will struggle to do better than 4.3% in any form of risk-free savings at the moment, let alone get £700 ahead - i've not tried the sums, so maybe there is a way with 6% regular savers and TSB accounts at 5%, but £700 doesn't feel right.

If your goal is a mortgage then I'd clear the debt now (certainly the loan, if it is long-term 0% on the CC then it might be worth minimums until 12 months or so before your mortgage application).

kidmugsy

cryozot wrote: »

1) I'm saving for mortgage deposit, going to the first time buyer in two years time -- that's my time horizon
2) I have circa £9000 of debt
3) Of that sum, £6300 is an outstanding amount on a bigger fixed term loan with 4.3% interest. I'm paying £170.54 a month
4) The rest of the debt (£2700) is on interest-free credt card with 2.5% minimum monthly payment, that's going to be circa £69 in June. The deal is going to go until Oct'15, after which I need to shift the outstanding balance to another similar card
5) I have £9000 in cash and I could repay all debt tomorrow

In your shoes I'd keep the free credit card debt, and pay off the other one. The reason is that anything returning 4.3% p.a. after tax is markedly riskier than just paying off the debt.

Be sure to keep a decent emergency cash fund in reserve. Have you thought about using the house buyers' Cash ISA that should be available in the autumn?
https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/413899/Help_to_Buy_ISA_Guidance.pdf

colsten

Averaged wrote: »

Your maths looks likely to be wrong to me - if you're paying 4.3% on the loan then you can't do better saving at 2.7%, and (assuming you are a taxpayer) you will struggle to do better than 4.3% in any form of risk-free savings at the moment, let alone get £700 ahead - i've not tried the sums, so maybe there is a way with 6% regular savers and TSB accounts at 5%, but £700 doesn't feel right.

Agree, there must be a fundamental flaw in the calculations of the OP. Probably forgot to take off the tax that will be due.

I also haven't done the sums with regular savers/TSB but I am pretty certain this wouldn't net 4.3% or more as it is not possible to deposit the entire sum on day one into this accounts.

kidsmugsy wrote:

In your shoes I'd keep the free credit card debt, and pay off the other one.

that would be my instant reaction too. Keep the 0% until the 0% rate ends, then try another 0% card, or pay it off. Keep your money in risk-free current accounts, and may be some in regular savings accounts, in the meantime.

Lomcevak

colsten wrote: »

that would be my instant reaction too. Keep the 0% until the 0% rate ends, then try another 0% card, or pay it off. Keep your money in risk-free current accounts, and may be some in regular savings accounts, in the meantime.

I tend to be fairly conservative in these things, but i'd pay the loan off now, and let the 0% card run until October 15 at which point i'd pay that off too.

You'd make a (fairly small) amount of cash if you rolled over the 0% to another card and Stoozed the cash to pay it off for another 18 months at 5%, but for a mortgage application you need to weigh the profit against having 12-18 months of no long-term debt on your credit record. Unless you have a sizeable deposit i'd be looking to keep my credit and outgoings (for 'affordability' assessment) as blemish-free as possible these days. Only needs another tenth of a percent on your mortgage rate to massively outweigh any benefit from Stoozing for a bit.

cryozot

Thank you guys,

These are all kinds of considerations I had in mind when was pondering the dilemma; however, the math pointed the other way and that's when I got confused. I'm glad I posted it here though, as your strong opinions made me to recheck everything and I did find few inconsistencies in the formulas. In particular, I'd assumed that I will not be saving money on the month of repaying the debt in the early repayment option, which shouldn't necessarily be the case, as I would be repaying from savings.

However, having checked everything, I still arrive to the same conclusion: holding on to cash is superior financially to repaying the debt early in my case. The difference comes from the fact that in the former case the entire sum attracts savings interest each month, whilst in the latter case savings grow gradually as time passes. Actual difference depends on the interest rate. For 2.7% it yields £226 in 25 months. It grows further to £662 if the entire sum is locked down for 2 years under 5%.

I guess the conclusion is that it's not necessarily the case that early repayment of debt is better strategy for everyone. Perhaps if one doesn't hold sufficient cash to clear the debt outright, it's always better to direct monthly payments towards the debt rather than to saving, as debt interest is going to eat into the return from savings. However, if sufficiently large lump sum is available, one should consider savings/investment as a viable option as well.

cryozot

By the way, is anyone interested in seeing the spreadsheet I used to work out the result for myself? PM me with your email address and I'll post it over.

Lomcevak

cryozot wrote: »

I guess the conclusion is that it's not necessarily the case that early repayment of debt is better strategy for everyone.

It depends, it's more complex than just always better or always worse - tax in particular comes into it.

These days I'd say that in general it is hard for taxpayers to make a significantly higher risk-free return on (non-mortgage) debt than you pay in interest on debt, so most of the time you're better off repaying debt before putting money into savings. But non-taxpayers could still do better in savings than repaying some low-rate loans

If you have a mortgage then even a basic rate taxpayer with a low-rate tracker or fixed-rate mortgage is often better off saving than paying down the mortgage. On the other hand, if you're looking for a mortgage then affordability can mean it's better to pay off debt than save, even if you could potentially achieve a net return from saving. And for higher-rate taxpayers, pensions are another example where the tax system can make it (much) better to save than repay debt. So ... it's complicated.

But these things come and go. Ten to fifteen years or so ago it was easy to get tens of thousands on 0% credit cards that could then be stashed away in savings earning 6% - I hit £45k at one point, and knew many people on TMF with much more. So back then you wanted as much debt as possible, provided that you didn't spend the money

bsms1147

If debt APR is higher than savings APR (after tax), then pay the debt with savings. What am I missing?

Thrugelmir

bsms1147 wrote: »

If debt APR is higher than savings APR (after tax), then pay the debt with savings. What am I missing?

Absolutely nothing. No requirement for spreadsheets either.

colsten

bsms1147 wrote: »

If debt APR is higher than savings APR (after tax), then pay the debt with savings. What am I missing?

You are not missing anything.

There is absolutely no chance that the OP can create a realistic scenario where the AER (minus tax) on their savings is higher than the APR on their debt - not with the interest rates currently available.