Saving money in a savings account while you have loans or other debts to pay off doesn’t make financial sense in the long run. Having a little nest egg tucked away might give peace of mind but that nest egg would grow a lot quicker if you paid off loans first and then started saving. The interest that you gain from even the best savings accounts will be much lower than the interest you’re paying on an outstanding loan and so you are effectively losing money all the time.

Over the last year or so, the interest rates on ISAs and other types of savings accounts have fallen so that the average rate is now around 3%. When you compare this to the interest rates that are being charged on debts you see that they have increased and the average personal loan interest rate is now between 8-11%. This means that if you have savings of £2000 and a personal loan of £2000 you are earning £60 interest per year but are being charged between £160 and £220 each year. This may not seem like a big deal when compared to the peace of mind of having savings to fall back on but these figures are only for one year. When taken over five years, which is the normal length of a personal loan, the difference can be several hundred pounds which then becomes a big deal for most people.

Paying off a personal loan with savings makes sense and it won’t take as long as you think to recoup your nest egg. Once the loan is paid off, you can then add the amount that you were paying for the loan each month to the amount that you regularly save and this money can be put back into your savings account. So for example, if you were paying £80 per month as a loan payment then this can be added to the amount you save each month. Once this is added to your savings account it begins to earn interest and with the additional payments each month, your balance will soon grow again. In this way you are earning more interest rather than paying it out.

Using savings to pay off personal loans does take a leap of faith, especially if you like to have the psychological comfort of an emergency fund. It does make financial sense though and with the additional payments to your savings account you will only be without your emergency fund for a few months.

It is important however that before you do this you check the small print of your loan conditions. Some loan agreements may incorporate an early repayment clause that means it costs more to pay the loan off before the end of the terms than you will save by doing it. This is especially true in the case of small loans or short term loans where the lender doesn’t make a large amount in interest. In general though, paying off loans with savings is the best option as you will end up with more money in the long run.