Weight loss and personal budgets have a lot in common. It's all about energy/money in versus energy/money out – and everyone has an opinion.
My column last week on whether it's sensible to simultaneously hold debt and savings aroused similar passions to any diet debate.
I wrote that it doesn't make strict financial sense because the interest charges on debt are higher than the interest earnings on savings – but noted there can be a psychological benefit because some people find it easier to pay debt than to accrue savings.
There is another element to consider: the nature of the debt itself and the purpose of the savings.
There are some types of debt you don't need to pay off straight away. The first is tax-deductible debt such as investment loans. The second is a HECS/HELP debt for higher education and since this only increases at the rate of inflation – that is, not at all in real terms – there's no compelling reason to pay it off voluntarily.
The third is a mortgage for your home. Actually, there are a huge savings to be made by paying this off as quickly as you can, but you can hold savings simultaneously by using an offset account.
Assuming we're talking about non-tax deductible debt that's not HECS and not an owner-occupier mortgage, then you need to consider the interest rate and time period of the loan.
If you're trying to amass a house deposit, remember any home loan provider will consider your net position, that is they may deduct your outstanding loan balance from the total amount they're willing to lend you, and they'll certainly take fixed loan repayments into account when assessing your available income.
Say you have a car loan of $20,000 with interest charges at 8 per cent a year for a fixed period of five years. Technically you're better off using savings to keep the loan as low as possible because you're unlikely to earn more than 8 per cent on your money.
However, as loans go this isn't bad, because the interest charges are below 10 per cent and there's a solid plan in place to eliminate the debt within a reasonable timeframe.
But if it's a credit card, it's the worst of both worlds – interest rates up to 22 per cent a year and no fixed period in which to pay it off. Same goes for an overdraft on your bank account, though this isn't common in Australia.
One reader suggested it was a good idea to have savings in an emergency fund while also having a plan to pay off debt, because then you have some buffer to make sure you don't go back into debt.
It's definitely wise to have a couple of thousand dollars socked away, somewhere accessible, so you don't need to borrow to meet unexpected expenses. Money columnist Nicole Pedersen-McKinnon calls it a "Holy Sh*t! Fund".
However, does it make sense to have a Holy Sh*t! Fund at the same time as debt? Perhaps if you're paying a fixed-term, low-interest loan such as car finance. You know what your repayments are so you can budget, and even if you're allowed to make extra payments, you generally couldn't get the money back out if you suddenly need it.
But please don't try to hold on to emergency savings at the same time as paying off a credit card debt. That's just prolonging the amount of time that you spend in debt because interest charges on credit cards are so high and interest compounds.
The credit card itself can be your Holy Sh*t! Fund until you get it paid off and build your savings. That's not an invitation to spend – put it on ice and keep it for genuine emergencies.
Imagine you have a credit card with an interest rate of 20 per cent and a savings account with an interest rate of 2 per cent. Say that after making your regular repayment in February, your credit card has a balance of $10,000 owing.
If you have an extra $200 this month, what should you do? If you put the $200 into a savings account, and kept the credit card debt at $10,000, you'd earn 33c interest on the $200 this month and by the way, small as it is, that's taxable income. You'd also pay $167 interest on the credit card debt this month and that's not a tax deduction.
So what about if you paid the $200 into your credit card instead? Then you only pay interest on $9800 in February, roughly $163 for the month.
If March brings you an unexpected and unavoidable expense of $200, what then? If you've paid it off your debt, you can always use the credit card and it goes back to $10,163, including last month's interest and before the next repayment.
If you've paid it into savings, you can withdraw it. You keep the 33c interest, but your credit card bill now stands at $10,167.
Now I know what you're thinking - that's only $3.67 difference, what's the big deal?
Look at it over a longer time frame. If you saved $200 every month for a year and earned 2 per cent interest compounding monthly, you'd earn $22 interest before tax over the year. If you put that $200 a month to paying off a debt with a rate of 20 per cent, also compounding monthly, you'd save $233 in interest payments over the year.
If you kept up the monthly deposits or repayments of $200 a month then over three years, you could earn $214 in interest before tax, or save $2558 in interest on your debt.
In fact, the calculator on the ASIC MoneySmart site says if you paid your $10,000 credit card debt at the minimum payment (which starts at $204 a month), it would take 61 years and 3 months to pay it off in full. You'd pay $42,073 in interest on top of the original $10,000.
If you instead paid $404 a month, you could clear the entire debt in two years and eight months. The interest charges would be $2722 – a saving of $39,351. By the end of three years you'd have no debt and $800, plus interest, in savings.
Tell me again which is the better strategy?
Of course, knowing you need to do it doesn't make it easy – just like weight loss. I'll write more about how to do it next week.