For the past twelve months I’ve been weighing the merits behind saving whilst I pay down my student loans versus throwing as much as I can at my outstanding balance and leaving my savings account to flat-line. And when I say savings I am talking about long-term savings here (ie. retirement). There may be a valid business case to save up for a car while you pay down debt (or even borrowing more to buy a car sooner). As we’ll soon find out, you just need to be sure the return outweighs the cost.
So I think the easiest way to show this is via Excel. But first a few assumptions:
- There are no tax benefits to saving money or paying down/holding debt.
- Inflation isn’t doing anything Zimbabwe’ish whilst you save in a different country/currency (or for all the economists in the room, purchasing power parity holds).
- There is no value/life experience to be had from saving your money whilst clearing your debt.
That last point is an especially important one. I could gain no personal benefit from learning the action of opening up – and depositing money into – a Lloyds 2% fixed-interest savings account. On the other hand, there may be something to be had from learning how to properly invest in stocks or other securities (even if my performance was equivalent to that of a 2% savings account).
Given the above, this is obviously quite a limited test – so please don’t rely on the outcome alone when making your investment decisions.
Alright, so let me put on my storytelling cape and hat in what will most likely be a god awful attempt to engage you in some compound interest magic.
Simon and Garfunkel both just graduated Kent University’s masters programme in management studies. They both came out with exactly the same amount of student debt – £60,000. Fortunately however, after much perseverance, hard work and dedication, they got a job. To the marvel of many.
After consulting with each other through the medium of song, they discovered that they would both be able to earmark the same amount of cash to pay down their debt (£10,000 per year). But Simon’s friends told him he was better than that; he could do much better if he abandoned the plan and saved some of that cash instead. Garfunkel was not averse to saving; he just knew where his priorities lay.
Simon saved 25% of his allocated income and used the remaining 75% to make payments on his loans. His debt had fixed interest of 4% and his savings 2% (see belief above). In the end, it took him 10 years to pay off the bank. When this was done he was sitting on a cushy £28,605.45 in savings.
Garfunkel stayed true to his heart and put 100% of his allocated income towards his loan. Just like Simon, he paid the same rate of interest. There’s no doubt that Garfunkel would, and did, pay off his debts first – three years sooner in fact. And with his debt now paid off, he was free to place 100% of his allocated income into a 2% savings account. By the time Simon had paid off his debt, Garfunkel was worth £30,632.70.
Even if Simon went on to place 100% of his allocated income into his savings, his net worth would never surpass that of Garfunkel’s. In fact, the gap between them continues to grow.
So that proves it. Given a higher rate on my loan I should not save any money until it is paid down. Annoyingly cheesy and condescending way to arrive at that point I apologise. But the fun doesn’t stop there. Now we can discuss the other considerations not tested.
For instance, what about the rationale behind saving an emergency fund? Assuming both of our singer-songwriters started off their working lives totally skint, Garfunkel took a risk not putting anything aside for a rainy day.
What about salary increases? What about only being 20-something once? Why save at all? Why not live so far below your means, that you pay your debt off in two years instead of ten?
Personally, I hate having debt (woah!). I think it is a necessary evil to take on debt in order to go down certain paths in life, but should be shed and avoided as much as possible thereafter and in every other circumstance. I have a conservative emergency fund and everything else I can spare goes to my loan. Otherwise I am borrowing to save (provided I cannot find an investment with a return larger than my debt’s interest).
P.S. Simon and Garfunkel are sweet.