The Financial Fairy Tales Blog

The economy has undergone a seismic change in recent years and historically low interest rates have radically altered the way people behave in the financial markets. A generation ago it was unusual for individuals to carry any personal debt other than a loan for a vehicle. Traditionally it was the case that savings accounts were built up for purchases of household items and most people only bought items when they had saved up enough money to complete a purchase. There has been an explosion in unsecured lending in recent years in the form of credit card and store card debt and much of this has been driven by retailers who have used credit as a means to fund a continued growth in sales. Shareholders and the markets have expectations of continued growth and it appears that this has been funded by a growth in credit. It is not uncommon for those with relatively high levels of debt to also hold savings accounts but the return on savings is usually linked to a base rate of interest which is currently at rock bottom. The low levels of returns on savings are discouraging new saving and is also creating an opportunity for savers to use their funds to reduce debts.

Clear Down Most Expensive Debt

Basic maths shows that it is better to clear down debts that are incurring charges of up to thirty per cent for a typical storecard than to leave savings in an account that is only earning around one per cent. The decision may not be so clear cut for some people but generally it is recommended that savings are used as a means to cut debt and it is better to start with debt incurring the highest rate of interest. It is important to look at the whole picture as there may be good reasons for not utilising all savings to clear down debt.

Remain Flexible For Genuine Emergencies

People still like to save for emergencies and it may be the case that if debt levels are reduced a credit card firm may decide to reduce a credit limit in order to reduce its own exposure to bad debt. This would mean that an individual may clear down some expensive debt but be left with little or no flexibility if faced with an emergency such as a defect in their central heating system which required urgent attention. With no savings or available credit to rely on there may be few options to resolve an immediate problem so it may be wise to retain some level of saving for such emergencies.

Consider The Term Of Outstanding Finance

It may be sometimes more important to clear debt which has a specific lifespan and would be difficult to replace once that time had elapsed. A saver may be faced with an option to clear an expensive storecard or a relatively low interest mortgage account. Whilst it may appear to be beneficial to reduce the expensive debt it may be the case that the mortgage debt has a fixed term which must be adhered to. If the term is allowed to expire and a solution to clear has not been found it may no longer be possible to simply ask the lender to extend the term as criteria for lending may have changed. In this case it would be more prudent to clear down a low interest account purely because of the fixed term involved. If debts appear to be complex and unmanageable then it may be appropriate to seek debt help so that an effective strategy can be developed. It is important to monitor the financial markets and review savings rates periodically because banks exploit consumer intertia by reducing interest returns on existing products whilst hooking new customers with attractive rates on new products. It may be the case that by switching savings accounts or products it is possible to achieve a higher rate of return that reduces the case for using savings to clear down debt, especially if most of the debt is held in a low interest mortgage.

Are There Short Term Alternatives Available?

Psychologically it may be important to maintain some level of saving as this buffer may offer comfort that would be eroded were a balance used in its entirety to clear debt. Maintaining some level of debt is not a bad thing either as credit scores are enhanced if debts are incurred and payments are met on time. This can be useful when applying for a mortgage as a potential lender will be able to form a view of a borrower that demonstrates a commitment to responsible actions when dealing with debt. There may be little value in removing savings early from a fixed investment plan to clear debt as early withdrawal penalties could offset any interest savings made by debt clearance. A better long term plan may be to seek a cheaper alternative form of credit such as a zero per cent balance transfer period to reduce interest exposure temporarily allowing time for fixed terms to expire so that the savings can be used to clear down debt in a timely manner that does not incur early withdrawal penalties.

Action Is Essential

It is clear that by not taking action there are likely to be inefficiencies in financial arrangements exposing individuals to low rates of return on savings and high levels of interest on debts. Whilst it may appear obvious that high rate debts should be cleared with low return savings it is important to review the overall financial situation and factor in long term objectives before making wholesale changes. The term of debt is an important factor as are assessments of medium term cashflow requirements and a balanced approach will lead to an optimum solution.