I’ve been hearing this little tidbit of advice, or something like it, for years. It’s a great little piece of advice for the not-finance-savvy mass public. A high-interest savings account is a great, risk-free way to see your money grow over time, and the results of putting in a little bit regularly will really add up.
But this comes with a major caveat that most people don’t hear: PAY YOUR DEBTS OFF FIRST!!
A typical high-interest savings account might pay something like 2% – 4% per year. Guaranteed term investments (GIC’s) and other products might pay a percent or so better because of your term commitment. Then again, your typical credit card charges an interest rate of about 18% per year, and many retail cards charge close to 30%! Pay these off FIRST. Entirely. BEFORE you open a savings account.
Here is a simplified example. Say you have a credit card with a balance of $2000, and an interest rate of 18%. Starting in January, you have $200 free income to invest every month. You decide to pay the minimums on the credit card (3% typical) and deposit what’s left in a savings account paying 4% interest. In one year, you’ve managed to pay down the credit card to $1,642.86, and have $1,768.32 in savings, earning $31.79 in interest for the year. Not bad, right? Until you factor in the $331.74 in interest you racked up on the credit card balance. You’ve lost $299.95 overall on your $2,400 investment, a net return of -12.5%.
Here’s another example. Same as before, but this time you put the entire $200 into repaying the credit card. By November, the balance on the credit card is paid off completely, and you start depositing the remainder into savings. At the end of the year, you only have $220.19 in savings, but the credit card balance of zero gives you a net loss for the year of $180.47 (-7.5%).
It doesn’t seem like much of a difference, and all that cash in savings looks good, right? Extended into a second year, scenario 1 returns a loss of 7.1% in year 2, whereas scenario 2 gives you a gain of 2.2%! And you’ll still be paying off your credit card and losing more money under the first method.
What you have to realize is that a payment to your 18% credit card is very much like an investment in a savings account that pays 18% interest, which is much higher than any real savings account will ever be. The only difference is that instead of earning the interest, you are instead offsetting interest that you would pay otherwise.
Side note: if you continued to pay the minimum on that credit card, you would pay off the balance in October of the fourteenth year. You would have paid $1,798.88 in interest over that length of time.
Another side note: paid-off credit cards look great on a credit report, so don’t close them once you’ve paid them off! Just cut them up so you don’t rack up a huge balance again!