Pay off debt or save? Try both
HERE'S a surprise. Research shows Australians are more comfortable with their home loan than any other aspect of household finances. But on the flipside, we’re least comfortable with personal savings. It begs the question, are we better off paying down debt or building savings?
According to ING DIRECT’s latest Financial Wellbeing Index, Australians are making a big effort to reduce their debt. Almost 50 per cent of mortgage holders are ahead with their loan, and 61 per cent of credit cardholders pay off their card in full each month.
But savings remain a weak spot. The same research shows one in four households have less than $1,700 tucked away in savings accounts or term deposits.
Knuckling down to pay off debt is a very smart move, but savings are important too. Without the back up of spare cash we’re vulnerable to unexpected expenses like car repairs or an unusually large power bill. When that happens, we often reach for our credit card, undoing all the good work we’ve done paying off debt.
However it pays to remember that not all debt is bad, and in some cases it can make financial sense to be in debt.
There’s no doubt that high interest credit card debt is disastrous. It’s easy to get hold of and can encourage us to live beyond our means. This sort of debt is worth eliminating as fast as possible and it gets plenty of people into serious financial trouble.
But some debt, like a mortgage on an investment property, is what I call ‘effective’ debt. That’s because it’s used to fund an asset that will grow in value, and the interest is tax deductible, which reduces the cost of the loan.
If effective debt is used to fund a decent asset - one with genuine prospects for growth, it’s worth taking on, provided you can comfortably handle the repayments.
Our home mortgage is similar. The interest can’t normally be claimed on tax, but the loan is funding a worthwhile asset. Nonetheless it’s worth planning to get rid of this type of debt as soon as possible as it can drain your financial resources.
‘Sadly necessary’ debts are those we rack up buying things most of us have to have, like a car. Now, cars are a terrible investment - they fall in value and cost heaps to run, but they’re a must for work and play. My advice if you have this type of debt is to knuckle down and plan it off early if you can.
If you’re concerned that paying off debt won’t leave you with much in the way of personal savings, it’s worth drawing up a financial action plan. Aim to put aside a small amount as regular savings - even $20 deposited each week in a high interest account is a good start. Then focus on paying down debt.
Aim to get rid of the high interest card debt first, followed by personal loans and finally your mortgage, which typically charges the lowest rate of all debts.
It may sound like a tall order but it is possible to enjoy the best of both worlds - debt that’s under control and a pool of spare cash for emergencies.
Paul Clitheroe is a founding director of financial planning firm ipac, chairman of the Financial Literacy Foundation and chief commentator for Money Magazine.