Using savings to reduce debt can save interest and simplify your finances, particularly when the debt is expensive. But using every dollar of savings can leave you vulnerable to the next unexpected expense. In summary, the interest on personal debt is not tax deductible and it can carry high interest rates, so there are benefits in paying down debt, but you should have an emergency fund for unexpected circumstances and bills. It is a trade-off.
Start With the Interest Rate on the Debt
The higher the interest rate, the stronger the financial case may be for reducing the balance. Paying off a credit card charging a high rate can produce a very different outcome from making an extra payment on a low-rate loan. Interest on these loans are generally not tax deductible.
Do You Have an Emergency Fund?
Before using all available cash, consider what would happen if your car needed repairs, you received an unexpected medical bill or your income stopped temporarily.
Could Paying Off Debt Force You to Borrow Again?
If clearing debt leaves no cash reserve, the next emergency may go straight back onto a credit card. This can undo the benefit of the lump-sum repayment. Personal circumstances are different but paying down your debt and building an emergency reserve are part of a prudent financial plan.
Consider the Type of Debt
High-interest unsecured debt often deserves greater urgency than lower-cost debt. Whether debt is fixed or variable and whether early repayment fees apply can also matter. If you havea car lease, the type of lease can impact decision-making.
What About Mortgage Offset Savings?
Money in an offset account may already reduce mortgage interest while remaining accessible. Moving that money permanently into the loan can reduce flexibility, depending on the loan structure.
Could You Split the Difference?
For some people, keeping a minimum emergency reserve and using savings above that amount to reduce expensive debt can create a balance between interest savings and financial flexibility.
Make the Decision in Context
At Setch Group, debt repayment is considered alongside emergency savings, upcoming expenses, income stability and longer-term goals.
If you are unsure how much cash to keep versus use against debt, complete the Setch Group Financial Healthcheck.
Frequently Asked Questions
Should I empty savings to pay off a credit card?
Not automatically. Compare the interest savings with the need to maintain an emergency buffer. If you are considering using savings to pay off a credit card debt then prior to doing so, do a cashflow and see how you would rebuild the savings or the emergency reserve.
How much emergency savings should I keep?
The right amount depends on expenses and income stability. Moneysmart suggests working towards a meaningful buffer for unexpected costs. If a particular event occurs then whether your savings or emergency buffer are enough will depend on the nature and longevity of the event. The right level is an aspect to having a financial plan and involves trade-offs.
Is an offset account the same as paying down the mortgage?
An offset can reduce interest while keeping cash accessible, but loan features differ.
This article contains general information only and not financial advice.
