Tuesday, December 20, 2016

Is It Better To Pay Off Debt Or Save Money?

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When Singaporeans are juggling debt, which is the smarter thing to do – pay off debts quickly, or save money for emergencies? If you have debt and no savings, you may be torn as which of the two to settle first. Without savings you can’t cope with emergencies, but the longer you retain debt the more interest you pay. Here are some handy guidelines Singaporeans can use to strike a balance between the two.
 
Paying Off Debt Versus Building Your Savings
The argument for paying off debt first boils down to interest. The longer you retain debt, the more you pay in terms of interest rates. However, it is not advisable to go for long periods without savings. This is because, without savings, you could fall into a poverty cycle. For example, say you are eager to repay your credit card debt. You pay S$3,000 of your S$4,000 to rush repayment. This leaves you with just S$1,000 to live on. But what happens if you get into an accident or some sort of emergency, which costs you S$2,000? Chances are, you will again use credit cards for the funds, thus leaving you further in debt. Not balancing between saving and debt repayment often leads to situations where your pay cheque disappears as soon as you get it (all of it goes into debt repayment), but at the same time your debt doesn’t seem to go away. The key is to balance between the two, by looking at your situation. See which of these applies to you:
 
Situation #1: You Have Debt You Cannot Repay in 1 Year
If you cannot repay the entire debt within the year, it is generally a good idea to repay the debt more slowly (admittedly paying more interest) while still building up savings. As a typical example, consider your housing loan: Say you owe S$200,000 on your HDB flat. You have managed to accumulate savings of S$15,000 over time. Your mortgage interest rate is 2.6 per cent per annum (this is extremely low, as a mortgage often has the lowest interest of any debt). You could try to speed up your home loan repayment, by immediately putting all S$15,000 into your mortgage repayments. But what would that leave you? Before rushing repayment, your position is (S$200,000 in debt – S$15,000 repayment) – S$185,000. If you were to put all S$15,000 into repayment, your net position would be (S$185,000 in debt – S$0 in assets)…still – S$185,000. Your net position has not changed at all. The only difference is that now, you also do not have savings to deal with emergencies. This is the reason why most people do not want to accelerate home loan repayments. You can apply the same concept to other forms of debt. If you cannot repay a debt in its entirety, and you would take more than a year to do so, then you will need a balanced approach. Set aside 50% of your monthly income. Of this amount, put 20% into savings, and the remaining 30% into debt repayments. For example: if you earn S$4,000 a month after CPF and taxes, you might put S$800 a month in savings, and S$1,200 into debt repayment. The exact ratio will differ based on how much you owe and the interest rate, so speak to a Financial Advisor for further help. Nonetheless, keep in mind that for debts you cannot repay quickly, you should maintain a savings plan while paying them off.
 
Situation #2: You Have a High-Interest Debt That You Cannot Repay in 1 Year
High interest rate debts include credit card debts. In these situations, you will need to restructure your debt obligations. Take a lower interest rate to pay off the high interest debt, and then save while paying off the cheaper loan. For example: Say you owe S$10,000 in credit card debt, which has an interest rate of 24% per annum. You could take out a personal loan of S$10,000 at 6% per annum, and pay off the credit card debt with it. You would then proceed to save while paying off the personal loan, as in Situation 1. The key is to get a personal loan with the lowest interest rate, and one of the best in the market right now is the HSBC Personal Loan. Singaporeans who apply through SingSaver.com.sg enjoy an exclusive low rate of 4.5% p.a. (EIR 8.5% p.a.), plus a waiver of S$88 processing fees and S$50 cashback.  
 
Situation #3: You Are Able to Pay the Entire Debt in 6 Months or Less
If you are able to pay off the debt in a relatively short period (six months is a general guideline), it often makes sense to pay the debt before saving. In fact, many banks offer interest-free balance transfers for up to six months, making this quite viable. However, if you choose this route, you must be disciplined and pay off the debt as soon as possible. Also, you should consider your circumstances. If there is a chance that you will need money urgently in the near future, you might still choose to save and pay off the debt slowly.

2 comments:

temperament said...

To me no debt is good debt.

Only there are necessary debts you can't buy or pay by cash.

Dividend Warrior said...

Hi temperament,

Being debt-free is a liberating feeling indeed. However, corporations do often use debt for expansion, so it is a double-edge sword. The key is to avoid overstretching our finances.

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