Should you save or pay off debt?

Posted on: 07 December 2009 by Mark O'haire

There's been a record fall in personal debt in the UK - but does spending money to pay off loans leave you exposed elsewhere?

Consumers wiped £713 million off their personal borrowing, excluding mortgages, secured loans and credit cards, in October, new figures from the Bank of England have revealed.

Despite credit card debt rising by £134 million, the outstanding amount we owe on unsecured borrowing fell to £228 billion - the largest month-on-month fall since Bank of England records began in 1993.

It also marks the fourth consecutive month that Britons repaid more unsecured debt than they took out.

Why are unsecured debts falling so fast?

Many Britons are concentrating on paying down their debts in a bid to prevent them spiralling out of control in this tough economic environment.

However, the low savings rates available at the moment are also a contributing factor.

The leading savings rates are significantly higher than the 0.5% base rate but even so they look unappealing in comparison to what was available a year or two ago.

The market-leading instant-access account from Birmingham Midshires has a headline rate of just 3.15%, including a 12-month bonus of 2.65%. So it's not surprising that many are choosing to plough money into paying down their debts rather than bolstering their savings.

Separate figures for October from the Building Societies Association (BSA) show that more money was taken out of savings accounts than was paid into them for the eighth consecutive month.

BSA director general Adrian Coles said: "There is little incentive for people to increase savings whilst the base rate remains at its current low level."

This is a double whammy for the cash-strapped banks and building societies as they are hungry for savers' money and are also losing out on interest payments on the debts being paid down.

"In the past people have been happy to have large unsecured debts, but the credit crunch and ensuing recession have prompted many to worry more about the amount they owe," said Tim Moss, head of loans and debt at Moneysupermarket.com.

"Interest rates on savings accounts also remain very low - although it is still worth shopping around as you can get more than six times the amount paid on the average account by switching to a market leader.

"It is therefore no surprise to see people choosing to pay off their debts, which often incur double-digit interest charges, rather than build up their savings."

Is it a good idea to pay down debts rather than save?

As you are likely to be paying a much higher rate of interest on your debts than you will receive on your savings at the moment, it is sensible to use spare cash to minimise your debt burden.

According to Moneysupermarket, the best personal loan rate on the market is still 7.8% from Blackhorse Personal Finance - more than double that on offer with the Birmingham Midshires savings account - and many people will be paying more than this on their loans and credit cards.

But beware: using all your spare money to pay down debts rather than contribute to a nest egg could leave you in hot water should you have an unexpected bill, for example.

"The main danger with using savings, or extra cash that could have been saved, to reduce debts is that people are left with little or no rainy day money should they need funds in a hurry," Moss explained.

While you might think that you can simply re-borrow the money you have paid back in the case of an emergency, that might be harder than you think.

In the case of credit cards and overdrafts, you can re-borrow the cash you pay back up to your credit limit - but this will be highly expensive to pay back with average overdraft rates at 15.53% and average credit card rates at 18.21%, according to Moneyfacts.co.uk.

On top of this, if you have cleared a debt entirely, taking out a new card or loan could prove tricky, with banks much more reluctant to take on new borrowers than before the credit crunch.

The best of both worlds?

One way to use your savings to reduce borrowing, while retaining the right to use the money should you need it, is to take out a flexible or offset mortgage that uses savings held in a separate account to reduce your mortgage debt.

First Direct is currently offering an offset tracker with a rate of 2.79%, while Clydesdale Bank has a two-year discounted offset deal at 2.99%.

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