Do you consider paying off debt to be saving?
I came across a young man who was in a quandry about paying off debt. He had over $10,000 of credit card debt, had no emergency fund but wanted to save for one, he also wanted to start his own business. For his business he considered he may need credit at some point in the future.
He wanted to know if he should pay off debt or save, which led the discussion into whether paying off debt is a form of saving.
Even if you’re in not in a position where you are in debt, I’m keen to get you perspective on this. How would you advise this young man?
If you have debt and you want to turn your position around, you may want to start to build some level of savings. That’s a sensible and logical thought process but I’m hoping this post will help you stand back and evaluate what you should tackle first.
There are a number over facets to his debt/savings predicament. Let’s tackle the core question first.
Is Paying Off Debt Saving?
To understand the benefit of paying off debt vs saving, consider for one second the debt as an investment.
The young guy owed money on his credit card. I don’t know what rates he’s paying but I pay 19.9% on my credit card so we’ll use that for this example. Reversing the mechanics of the debt and considering it an investment we would be seeing a rate of return on that investment of 19.9%.
That would be a phenomenal rate of return, right?
What’s more, this is a guaranteed, risk free, rate of return with no tax applied to the interest.
If I compare and contrast that to a standard savings account here in New Zealand I’d be lucky to be getting 3%, perhaps even 4% on a term deposit.
Imagine this standard savings account as your second investment option.
Which of the two investment options would you put your money into?
It’s a no brainer, I think we all would go for the higher investment.
In this respect, paying off debt can be seen as a form of saving, because without paying down your debt on your credit card you are going to be charged 19.9%. Whilst you aren’t increasing your investment, as you would be with the savings account, you’re avoiding your funds going in the other direction.
Paying off the debt is effectively an instant, guaranteed return that puts money back in your pocket.
Saving for an emergency fund vs paying debt
To quickly remind you, I had a small $1000 emergency fund saved up. I decided, rightly or wrongly, to use that money to pay down my 19.9% credit card. That card is now, fortunately, paid off.
At the time, I considered that a sensible decision. Why else would I have raided such funds otherwise?
But then Murphy came along and decided to teach me a lesson.
My washing machine broke.
Then my car broke.
Then my son ended up in hospital (I’m so grateful to live in a country where healthcare is free).
It was a crappy month to say the least.
I was flat broke and the stress that could have been avoided by having an emergency fund became unavoidable.
At that point I realised that I had not fully comprehended the purpose for, and benefit of, having an emergency fund saved away.
Sometimes having money close to hand, for genuine emergencies, is worth more than 19.9%!
Consequently, my advice to anyone would be start to save for an emergency fund if you don’t have one, but prioritise paying off debt in parallel if you have to.
In the instance of this young man I’d recommend he split a small portion of his surplus cash to start to build up an emergency fund as he is paying off debt. The alternative would be to use all available cash to build a complete $1000 fund and then move on to pay off debt. Really, each and every scenario has to be weighed up against the costs.
For example, if this young man had $400 of surplus cash available each month to pay off, after his living expenses and minimum debt repayments I’d recommend him putting $50 into an emergency fund and paying $350 toward his debt.
Getting out of debt, keeping out of debt
The young guy had plans to start his own business in the future. I don’t have specifics about what business he is planning on going into but many people would consider that they need to go into business carrying debt. This is blind thinking.
An approach to funding a new business should carry the same methodologies as your own personal finances. If you’re realising being in debt in your personal life is a bad idea then apply the same thinking to your business!
Depending on the type of business you are heading into there are a plethora of ways to build a business without needing a bucket load of debt or capital to get you going – think Bootstrapping, but let’s go there another day. Validating a market for your business is essential too, again, a conversation for another day.
In a nutshell, getting out of debt and keeping out of debt requires a change in mindset and a stringent adherence to keep on track long term. This includes stepping out of financial decisions and viewing the situation as to whether what you want to achieve can be done in another way or through other means.
What do you think?
How would you advise this guy if he started to talk to you about his situation? Let us know in the comments.