Why You Should Pay Off Your Debts

For some people it is a dilemma whether they should pay more off a debt or put their cash aside into a saving account.

Debts are expensive
For most of the debts, the simple rule is to pay them off with savings if you can. The calculation is simple: If you owe $1,000 credit card debt at 15% interest (credit card rate can be as high as 40% these days), it costs you $150 over a year. If this $1,000 savings is put in a bank account paying 4% interest, it earns you only $40 a year. You don’t need a degree in math to figure out that you are losing. Debts usually cost more than what savings can earn, so cancel them and you are better off.

But what if there is an emergency?
Let’s forget about income tax for the moment just for simplicity’s sake and see a real life example:
My friend Tom has $5,000 saving, his bank pays him 3.5% interest. He also has $5,000 debt on his credit card. The card company charges him 15% interest. In a year’s time

Tom earns:

$5,000 x 3.5% = $175

He pays:

$5,000 x15%=$750

Every year, Tom is losing $575.

Scenario 1: Tom pays off his debts completely
He has no saving and no debts and relatively he is $575 better off. Even better, if he could put aside the amount of money, which he would otherwise have lost, into a saving account, he will be able to use that as an emergency fund in the future.

If there is an emergency and he needs $5,000 to fix it. He would have to use his credit card again. He will end up with $5,000 minus the money he manages to save, and will be paying less than $750 interest per year.

Scenario 2: Tom does not pay off his debts
If Tom doesn’t paid off his debt, when emergency happens and he has to use all his $5,000 saving to fix it. What he will be left with is $5,000 debt and no savings. He still has to pay the $750 interest every year.

Look at these two scenarios you can see whether there is saving or not if there is an emergency, Tom will be in more or less the same situation. However, if there isn’t an emergency, he is $575 better off every year, and debt free. Because he is debt free with savings, it is very unlikely that he will be rejected when he requires that $5,000 loan.

The exceptions
There are exceptions when you don’t want to pay off your debts, instead the more debts you are able to get the better, if you play game carefully. At times when the high street saving interest rate is high, and credit card companies want to entice you to spend more by offering you 0 percent credit cards for a period of time (it varies from 3 months to 18 months). You can actually make money by owing the credit card companies more money. Simply use the plastics for all spending, put your cash in a high interest saving account, only repay the minimum amount required and wait for the interest to grow.