Is It Better To Pay Off Debt Or Save Money

As a raw answer yes. It's generally worth having three to six months' worth of expenses put aside in savings in case of an emergency. Certainly for loans, mortgages and other fixed repayment borrowing.

Yet there is an exception for credit cards. Emotionally, many will find what I'm about to say difficult to deal with. The idea of having some cash in a savings pot feels safe, especially as traditional budgeting logic berates us to always have an 'emergency cash fund'.

While it's the right aim, for anyone with expensive credit card debt – where you can borrow more without applying for a new product, there's a better way.

If you were to pay off your debt with your savings, but without then cutting up your credit cards, it's important to keep the credit available in case of a substantial emergency (and substantial means just that, your roof falls in or you can't feed the kids; not a new plasma TV).

A practical example: Johnny Comelately

Johnny Comelately currently has £5,000 saved up, earning 1% interest, in case of emergency, yet he also has £5,000 on credit cards at 18%. While his savings are earning him £50 a year, his debts cost £900. Overall, he is paying out £850 a year.

Now compare what happens if he pays off his debts with his savings, with not doing so:

Situation A: No emergency happens

No change. Keeping both debts and savings costs Johnny £850 a year.
Pay off debts with savings. Johnny now neither earns nor pays any interest, thus is relatively £850 a year better off, and all the new cash he puts aside can go towards genuinely saving.

Situation B: After a year he has to pay £5,000 for an emergency roof fix

No change. Johnny uses the savings for the emergency. This leaves him with no savings and £5,000 of credit card debt at 18%.
Pay off debts with savings.As Johnny has no savings, he has to borrow the £5,000 on his credit cards. This leaves him with no savings and £5,000 debt on his credit card at 18%.

In other words, Johnny is in exactly the same position in situation B, regardless of what he does. Yet before the emergency he was £850 a year better off by paying off his debts with his savings.

The risk here is in the meantime the credit card firm cancels his debt facility, but that is rare, and you should have notice.

So overall, whether an emergency happens or not, the best result is to pay off your credit card debts with your savings.

The disciplined exception

Those making a concerted effort to repay serious debts may find the idea of reusing credit cards a real danger. Yet while it isn't a sensible strategy to have an emergency fund, as there's no guarantee you'll ever need it, there is some justification for making small savings provisions for specific future events.

For example, saving a small amount each month towards Christmas (see budgeting article), for those who can't trust themselves to stick to the limit on credit cards, is a sensible personal financial strategy. Yet keep it to limited amounts of cash.