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Should you Pay off Debt or Build Savings?

April 4, 2012
3 mins
A young woman leans over a man's shoulder to talk about something on the computer screen

As much as we all like seeing the balance in our savings accounts grow, aside from having enough cash on hand to pay your bills and daily expenses, it almost always makes more sense to pay off your debts first. Here are why – and a couple of exceptions to that rule.

Pay off your costliest debt first

No matter what kind of debt you’re carrying, it’s always going to be substantially more expensive to borrow than what your bank offers you in savings account interest. Figuring out the order in which you should pay off your debts first is easy: pay them off in order of highest to lowest interest rates charged.

Typically, your credit cards are going to be your most expensive form of debt. Outside of short-term, introductory rates, most cards charge 20 to 30 percent interest. Of course, you can find much better rates with a low interest credit card – but regardless of the percentage, interest charges on any unpaid balance are retroactive to the time of purchase.

Next up are car and student loans. Financial institutions are keen to extend these long-term, profitable loans to customers – and, with the latter, the hope that they become your home for future financial business – they generally offer them at rates a few points above prime. Once all your credit cards are fully paid up, pay down that student or car loan, again, focusing on the most expensive one first.

In the clear so far? Great, now you can take a look at your line of credit. An unsecured line of credit is going to be charged at a slightly higher rate than one that’s secured against collateral like you home.

Finally, if you’re fortunate enough to have all your other debts paid in full, then you should focus on making overpayments to your mortgage. Just make sure you don’t exceed the amount you’re entitled to – typically 20 percent of the principal per calendar year - but check your documents to make sure and to avoid any penalties.

The exception to the rule

When it comes time to apply for a mortgage, all your debt is going to count against you. (The banks will even add up all the credit limits on your cards to figure out how much potential debt you could accumulate.) But they’re also going to want to see some evidence that you have money available to make a down payment. First-time homebuyers can withdraw up to $25,000 from their RSPs (so $50K for a couple) through the federal Home Buyers’ Plan.

Otherwise, a mortgage lender is going to want to see bank statements or other investments showing that you have enough money available to make at least a minimal (five percent) down payment.

Also worth keeping in mind is that for every point below 25 percent your down payment you’ll pay an escalating rate of mortgage insurance. For more on that, see “The (Additional) Costs of Buying A Home.”

Emergency Preparedness

While only a crazy person would squirrel away their life savings in the proverbial mattress, it is wise to have some cash on hand for emergencies. Many people in Ontario were caught off-guard during the Great Blackout of 2003 when they discovered that none of the ATMs they relied on to access their bank accounts were working. At the same time, credit card systems were also down, so they found themselves in a temporary cash-only society. For a single person, $100 to $200 should be enough to tide you over for a couple of days of crisis. If you have a family, consider how much money you’d need to feed and provide for everyone for 48 hours.

Allan Britnell

Toronto-based freelancer Allan Britnell is an award-winning writer with nearly 20 years’ experience. He covers a diverse range of topics, including DIY and professional home renovation projects, nature and the environment, small business, personal finance, and family and health issues. He is also the managing editor of Renovation Contractor, the publication written for small- and medium-sized contracting and custom home building companies. He lives in Toronto with his wife, two daughters, and their dog, Oscar.

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