Martin Lewis’ ‘1,000 rule’ on using savings to pay off credit card debt

The money saving expert explained when it makes financial sense to use savings to clear debt on his BBC podcast

Martin Lewis has outlined a crucial credit card principle for savers whilst explaining the optimal time to settle outstanding debts. The money-saving guru addressed the topic on his latest BBC Podcast, responding to a listener’s query about the most effective way to utilise savings.

He employed a £1,000 example to demonstrate how the calculation works and help people understand the potential benefits.

Listener Dan enquired: “You’ve talked about whether you should pay off any debt before savings and investing. Does this apply to mortgages.”

Mr Lewis explained that the key consideration was whether an individual would benefit more from actually deploying the funds.

He stated: “My general advice about debt is you should always pay off expensive debt before saving. It does get a little bit more contentious because you also want to have an emergency fund.”, reports the Mirror.

“It depends on the nature of the debt that you pay off. The emergency fund is there so you don’t have to pay off even more. Credit cards are quite simple because credit cards are an open ending system of borrowing.

“So if you think about it, if you’ve got £1,000 on a credit card and you’ve got £1,000 in savings, the credit card is costing you 20 per cent, the savings are gaining you 4 per cent. You gain 16 per cent if you use the savings to pay off the credit card.

“And the advantage with the credit card is once you pay the credit card off it can sit there at a zero balance and if you have an emergency because you now don’t have any savings you can just borrow back on the credit card and you’d be in no worse a positio but you would have saved the interest meanwhile.”

This means someone carrying £3,000 of credit card debt would incur £600 in charges, whilst having £3,000 tucked away in savings would generate £120. Regarding mortgages, he explained: “The general rule of thumb is this – if the mortgage rate is higher than the after-tax rate you can earn on savings – so let’s say you’ve got a 6 per cent mortgage and then 4 per cent in savings – then you are generally better to overpay the mortgage, making sure the payments go towards reducing your capital which will effectively reduce the amount of time you have left to pay on the mortgage .”

He added: “If the savings rate is higher than the mortgage rate, then you are probably better off to save – with a couple of caveats. First of all I’d go on to a mortgage overpayment calculator because if it’s very close between the two generally overpaying your mortgage will win because of the vagaries of the way interest is worked out.

“But also if you reduce the amount of your mortgage debt, if you’ve got quite a high proportion of borrowing to your house’s value if you reduce the amount of your mortgage’s debt, you reduce the loan to value which could mean you get a cheaper mortgage when you come to remortgaging.

“The two big caveats to overpaying your mortgage are – first of all I’d always have an emergency fund in liquid cash because if you overpay your mortgage and suddenly something happens that you can’t pay it any more, that’s not going to start the bank going ‘oh you’ve overpaid so don’t worry about paying us now’. They’re still going to put you in arrears.

“And second you need to check that there aren’t any overpayment penalties.” He clarified that typically mortgages permit individuals to overpay by 10 per cent without incurring penalties. To hear the complete podcast, click here.