What's better: save more or pay off debt?
Your debts will generally grow at a faster rate than your savings in a savings product
When you think about improving your own financial wellbeing, you may wonder if it's better to start saving or paying off your debts. Or is the magic bullet somewhere in between?
The savings rate of an average South African household is at 3% - the lowest of all the G20 countries.
What this means is that for every R100 of after-tax income that a household earns, only an average of R3 is put toward savings.
The problem when a country has a persistent lack of saving is that it results in a “sandwich generation”, where people take care of both their elderly parents and their young children. And it eventually places a strain on government’s budget planning as more people will rely on social support when they are no longer able to earn an income.
When you think about improving your own personal financial wellbeing, you may wonder if it is better to start saving immediately or to start paying off your debts. Or is the magic bullet somewhere in between?
You will often hear professionals in the financial services industry encouraging you to start saving and investing more. The logic is that saving allows you to build long-term wealth and through the benefit of compounding over time, your savings and investments may one day provide you with enough income to live from or at least supplement a salary.
The simplest form of saving is through a fixed deposit at a bank, where the rate of interest that the bank pays you is typically linked to the repo rate, the rate at which banks borrow from the South African Reserve Bank and currently at 6.75%.
The longer the investment term of your fixed deposit, the higher the interest rate you receive.
Alternatively, you can invest in a unit trust from a registered asset management company. Unit trusts give you exposure to more diverse investments like shares, bonds and listed property. They generally have higher risk when compared to fixed deposits and can therefore result in higher returns.
While the nudge to save is noble advice, it misses a key element in the equation - your debt.
A more important question then becomes: given your limited financial resources, and the choice of either saving any surplus funds or using these funds to pay off your debt, which decision will leave you better off in the long run?
The simple answer is that you are almost always better off paying off your unsecured debts rather than saving your money. This is because when a credit provider gives you credit, by way of say a credit card or a clothing store account, it does so after having assessed your ability and likelihood to repay the loan.
Because these credit providers do not require you to give any security or collateral for the debt, they charge a high interest rate to compensate for borrowers who may fail to repay as they cannot easily sell any of your assets to recover the money you owe.
When credit providers determine how much interest to charge you, they start with the prime rate as their base. The prime rate is currently at 10.25% - much higher than the repo rate, so you can see why your debts will generally grow at a faster rate than your savings in a savings product.
Here are some tips to consider when weighing up saving more vs reducing debt:
- Pay off your debts before starting saving aggressively.
- Avoid taking on new debt.
- While paying off your debts, set aside a portion of your income in a savings account for emergencies so you don’t need to borrow when disaster strikes.
- Once you have settled your debts, speak to your financial adviser about starting your saving and investing journey. This will help you decide which savings and investment accounts are best suited for your goals and which will save you the most in tax.
* Siwundla is the investor relations and product analyst at CoreShares