Retiring Debt versus Saving

Retiring Debt Versus Saving

Which is better? Fast-track your mortgage, clear all your debts and then start saving, or take a bit longer to get out of debt and start your savings programme earlier? This is a question we often get asked.

In an ideal world, people would pay off their mortgages as quickly as possible and start saving for their retirement as early as possible.  However, things are a bit different in the real world. 

Periods such as now when there are low interest rates can be ideal times to pay back as much principal as possible. It seems that the banks have collectively decided it is now beneficial to have borrowers use floating interest rates rather than locking in longer term fixed rates. The reason is logical. They can make a higher margin on floating rates rather than fixed rate mortgages. It is also advantageous for the Reserve Bank when it wants to either stimulate or slow down the economy. Changes to the official cash rate lead to prompt changes in floating mortgage rates. Of course a combination of low interest rates and less than buoyant property markets can be advantageous for making very good value purchases.

The general aim should be to clear debt as quickly as possible. However savings should not be neglected.  A good rule of thumb when there was plenty of job security was to have three months’ living expenses saved and tucked away earning interest - but still readily accessible in an emergency. With a much tighter job market such as now, three months savings could be insufficient.

Once you’ve got that sorted out, your priority should be to retire debt.  The longer you take to pay off a debt, the more you end up paying because the interest is always accumulating on the amount still owing - leaving you with less to spend or save.

Suppose you get a wage or salary review and end up with another $100 in the hand each week.  You can do any number of things with the extra money: raise your standard of living and spend it, save it, or pay off debt.  It’s your money and you’ve worked hard to get it, so it’s a good idea to treat yourself a little.  Just so long as you don’t spend all of it.

So, that leaves you with the choice of saving the rest or using it to retire debt.  To make it worthwhile to save it rather than clear debt, you would need to get an after-tax return greater than the interest rate you are paying.  That means, if your mortgage is 7.75% and you are a high income earner on a 38% marginal tax rate, an investment would need to return 12.5% before tax to justify itself.  Some investments do that every so often, but not year in and year out.  It is extremely unlikely that you will find a safe investment providing that level of return or more.

As well as clearing debt as quickly as possible, you also need to access the lowest possible interest rate.  That means controlling your debt, being careful about things such as hire purchase agreements and putting expensive holidays on the credit card unless you can clear your credit card debt within the interest free period. 

If your debt does start mounting, one way to bring it back under control is to consolidate it into a single loan at a reasonable rate.  This is commonly done by adding it on to your mortgage.  While that has its attractions, it can also be a trap if you keep adding to your mortgage and taking longer to pay it off.

The bottom line is that the sooner you retire debt and start saving, the better off you will be in retirement.  Savings over an extra 5 or 10 years can have a huge impact on how much money you have when you retire.  The compounding effects of paying off debt early can be very substantial, and could make a significant difference to your standard of living in retirement.

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