Comparing Apples To Oranges: Saving Ahead Versus Paying Down Debts

On Thursday, I wrote about using a savings account to save up money, then using that amount to pay off a debt. This triggered the following comment:

I’d be interested in hearing the benefits of doing the “savings” account method of paying off the student loan vs paying extra towards principal every month.

Here’s the scoop. Directly comparing prepayment of a loan versus putting money in a savings account and using that to pay off the loan, directly prepaying the loan will always cost less in the long run assuming the loan interest rate is higher than the savings account interest rate.

So why save ahead in a savings account? Why not just directly pay off the loans? The reason is that while the money sits in a savings account, it also functions as an emergency fund so that, in the event that disaster strikes, I don’t have to take out another form of debt to cover the emergency.

Let’s use an example of a $10,000 debt at 10% annual interest over 5 years (basically, a bad car loan). The payments on this loan would be $212.47 a month. If you wanted to get it paid off in two years, though, you need to add another $257 a month to the payment or put $262 a month in a HSBC Direct savings account (earning 5.05% APY) and use that balance to pay off the loan in two years.

But let’s say that car’s transmission falls apart halfway through? You have to cough up $3,000 for the transmission (this is a completely hypothetical amount – if you are tempted to shout “but a transmission won’t cost $3,000!” you’re missing the point), but you’ve been paying ahead on the loan instead of using the savings account. Suddenly, you have to dump $3,000 on a credit card at what’s likely a much higher interest rate (if your car loan is at 10%, your credit is probably such that your credit card rate is in the 20s). On the other hand, if you’ve been using the savings account, you can just withdraw the $3,000 from that, pay for the transmission, and you’re in far better shape because you still just have that 10% loan that’s not late at all.

Using the savings account for “prepayments” is a way to have an extra-large emergency fund and still be able to pay off a loan early. It’s not as cost-effective as prepayment in the event that everything goes well, but it can be much more cost effective if disaster strikes. My wife and I like the comfort of having a giant emergency fund for such situations, so we are using this method for debt prepayment.

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  1. paidtwice says:

    Thanks for answering my comment question :)

  2. kim says:

    Don’t forget the tax implications. The interest made in the savings account is taxed. The amount of money gained through paying off the loan early is not.

    It doesn’t change anything about the situation, just another point to consider.

  3. Kathryn says:

    I like the idea of the extra “emergency fund.” IF that $3000 car repair came up and you had to borrow money to pay it, then you would have TWO payments to cover each month from your paycheck–the original debt plus a payment for the loan you took out to pay the transmission.

    When you prepay on a regular loan (such as mortgage or car loan), the payment amount is fixed, whether you owe 30 payments or just a couple more payments. So, with prepayment, your cash flow doesn’t improve until you actually pay off the loan completely. Having the money set aside in a savings account can make a big difference when an unexpected expense arises that would be difficult to handle in your monthly budget.

  4. Kristi says:

    Because I’m a teacher, I get a 3% interest rate on my student loans, which is just fantastic. I think I’m going to get an HSBC account and pump extra money into it to pay off my loans, that way the bank will pay my interest and part of my loan too since the interest rate is higher than the loan.

    Thanks for the idea!

  5. Brent says:

    I understand the basis of your plan, and I do like having a bit of a nest egg for emergencies.

    However, I belong to the Dave Ramsey school of no debt no way. From what I have seen, most people lack the discipline to keep that savings untouched unless there is an emergency. The proverbial dollar burning a hole in the pocket.

    By getting rid of the debt now, there isn’t that temptation to just take half of it and reward yourself with a Plasma tv, or something like that.

  6. Heath says:

    I haven’t got an emergency fund per se. We just made our last non-mortgage debt payment this week. We haven’t paid a penny of interest in the past two years because of 0% no transfer fee offers that we watch for and it seems that these are my emergency funds if needed. I am going to be focusing on savings, but mainly for college for my son rather than 4% cash in the mattress.

  7. Laura says:

    I too subscribe to Trent’s theory. For the simple fact that life always seems to throw you a curve ball. In a perfect world it makes sense to do the debt snowball and throw everything you have at it, until say the furnace quits in the middle of December in the Midwest, and you have no reserve to pay for it. After getting burned, I still follow the budget and save the rest, after I reach a certain amount in the savings acct, then I make a huge lump sum payment, besides the regular monthly payment, until it’s paid off, then move to the next one. I know I am still paying interest, but the security blanket is a comfort when something like that happens, and you’re not left out in the cold, literally. As a bonus, I learned a lot about energy efficiency, lots of rebates offered by the utility companies, manufacturers, and a tax deduction for energy efficient appliances, or upgrades. My home was insulated nearly for free. With the utility savings, my savings is a lot bigger. Bottom line, that’s what it’s all about.

  8. rasputin says:

    Hmm. But you can’t assume (it’s just not logical) that the $3000 needs to be paid back to the creditor in one scenario but not to yourself in the other. That creates an imbalance in your numbers.

    Given 1) you start with $3000 in the bank, growing at 5.05%, 2) you sign a $10,000 car loan for 5 years at 10%, and 3) at exactly two years into the loan, you have to cough up $3000 for a repair. You are given two choices. Either use the emergency fund then pay yourself back while taking 5 years to pay off the loan, or use a credit card to borrow the $3000 at say, 13.99% while paying more on the loan to get it paid off in 3 years. Which is better?

    Using the emergency fund, after 5 years you will have paid $12,748.23 on the loan plus $3000 to yourself. Meanwhile, the savings account will have grown $652.36 interest. That’s $15,095.87 total out-of-pocket.

    Using the credit card, after 5 years you will have paid $11,616.19 on the loan plus $3690.66 on the credit card (3 years at 13.99%). Meanwhile, the savings account will have grown $859.67 interest. That’s $14,447.18 total out-of-pocket.

    Even accounting for taxes taken out of accumulated interest, I would still go with paying off the loan more aggressively. Works both mathematically and psychologically. Who wouldn’t want to pay less and end up with more?

  9. Eric says:

    I have to agree that the tax benefits help a lot. Compounding interests also is a great thing about that.

  10. Mariette says:

    I too agree with Trent on this. I have debt I am currently paying down, rather than focusing all of attention on tackling the debt I set aside money for an emergency fund. I got very ill recently which came out of nowhere since I am young and normally quite healthy. The emergency fund saved me from going further into debt while I dealt with my illness. I can’t understate it’s importance. If anyone is interested I posted a blog today on BoulevardR which talks about this more in depth along with a couple of other topics.

  11. An excellent exmaple and overview on this subject matter.

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