One of the eternal questions about spending money is whether it is worth paying off the loan before you start saving or investing. In the wake of common sense, it seems reasonable to pay off your loans before you start saving, but it’s not quite so black and white. There are many factors to consider between the payment of a loan and the saving, and there is no one right answer to the question.
Loan rate vs. saving gains
When weighing the profitability of paying off a loan and saving it, you first need to answer the following question: Are the interest costs of the loan higher than the savings on the investment / investment?
In simplified terms, if you spend more money on the loan’s interest costs than the savings on the savings, you may want to focus on paying the loan. The same applies the other way around: If the interest costs on a loan are lower than the savings on the savings, you should prioritize the savings.
However, despite this rule of thumb, there is no clear answer to the question of paying off a loan or saving it, which would apply to every situation. There are many case-by-case factors that need to be considered when making a decision, so everyone must think about their own situation to find the most appropriate solution. In the following paragraphs, we will elaborate on the relationship between loan repayment and saving.
Loan payment first
Most always, the interest cost of a loan is greater than the savings on the savings, which is why the payment of a loan before saving is usually a sensible solution.
Let’s take an example where Väinö has savings of $ 5,000 (savings account interest rate 1.0%) and also has interest-bearing credit of $ 5,000 (interest rate 8.0%). In practice, Väinö’s net worth is 0 €, which decreases all the time as the credit grows. If Väinö pays off all the debt with his savings, Väino’s net worth is still 0 €, but the net worth has stopped decreasing, meaning that Väino will not lose any more money. From now on, any money left in the savings will actually increase Väinö’s net worth.
On the other hand, mortgage rates are currently at record low levels, which may not be the most economically viable solution, at least not to make additional loan repayments. In this case, it might be wise to invest the extra money wisely or seek a high-interest savings account.
According to another school, it is best to pay off your loan as much as possible when interest rates are low, to keep the loan as low as interest rates rise again at some point. This may make sense especially for those who are just beginning their mortgage payment contract.
When evaluating the profitability of saving and investing, it is worth remembering that the profits from both are taxable income. Withholding tax is 30% on interest income on savings, while capital gains on investments are taxed progressively (30-34%).
Sometimes prioritizing savings may be more sensible than paying off a loan. By far the most important reason to save before paying off your loan is to save the emergency fund for a bad day. Even if the savings are no more than losing the interest on the loan, a small emergency fund can prove invaluable in the event of unexpected expenses. If there is no emergency fund, unexpected costs may require additional debt, which in turn can lead to a debt spiral.
Often the size of an emergency fund is the equivalent of spending several months, but saving a smaller buffer fund is enough when paying off a loan. For example, a ton or two already covers many of the typical unexpected expenses, and virtually all the money you save is always home when unexpected expenses hit.
If the loan has a really low interest rate, as it is currently the case with mortgages, everyone can, at their own discretion, consider whether it would be more profitable to invest a portion of the funds that would otherwise be used to repay the loan.
In practice, it may make sense to have a balance between paying off your loan and saving it. You should try to pay off the loan as efficiently as possible to avoid high interest costs while putting small amounts in savings.
Although this will end up paying more interest than concentrating on paying off the loan alone, a small hedge fund can prove to be really important in the long run. If the emergency fund avoids taking on new debt in case of unexpected expenses, the slower pace of loan repayment has post fruit. In addition, a reasonable amount of money in savings brings peace of mind to many.
Borrowing should always be carefully considered and your own ability to pay realistically. However, if you need to take out a loan, it is crucial to compare loan offers before making a decision. Is a wild differences, so comparing loans can end games to save lots of money loans in total costs!