If you’ve got money to put aside, putting it in a savings account would seem to be the sensible option. But there are plenty of other options that could be better for you.
To help you decide where you should be prioritising your extra cash, I’ve created this ‘savings pyramid’. It’s inverse, meaning the pointy bit is at the bottom.
Start at this lowest tier, and then work your way up. Not every level will be relevant to you, and your own needs and goals might mean you skip some or even tackle a few at once.
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Clear expensive debts
If you owe money, this should be your priority. The amount you’re spending on interest repayments will likely outweigh the gains you can make elsewhere.
For example, the average credit card interest rate is 36% and the typical overdraft is close to 40% APR. Owe £1,000 at these rates over 12 months and it’ll cost you £360 to £400. Putting the same amount in a savings account paying 4% would make you just £40.
So, funnel as much as you can afford into clearing the money you owe, starting with the most expensive interest rate. And that means use any existing savings, not just new cash you earn each month.
I know it might feel safer to have some savings ready in case of an emergency, but it doesn’t make financial sense to do this while you have expensive debts.
If an emergency comes along, yes you’ll likely need to borrow to fund it, and that debt could be expensive. But it might not. And in the meantime you’ll still be getting charged huge amounts in interest.
It’s important to add here though that we’re not talking about all debts. For example, if you can move your credit card balance to a 0% Balance Transfer credit card or have bought something at 0%, you only need to cover the minimum repayment each month. The cash you would have put towards it can instead go less expensive debts, or if you don’t have these, into savings and earn interest, ready to clear the entire balance when the 0% period ends.
Equally mortgages don’t count here (they will do later). Nor do student loans, which in the most part shouldn’t be overpaid.
Watch out too for any debts with an early repayment penalty, as you can get with some loans. You’ll probably want to avoid making the last payment on these until that final due date, though you can ask for a settlement figure to know exactly what it would cost to clear it early.
Snowball or avalanche?
There are two key methods for clearing debts. Snowball means you clear the smallest debt first before moving on to the next. Avalanche focuses most of your cash on the single debt with the highest interest rate, and once that’s cleared you start on the next most expensive.
Mathematically, avalanche makes most sense, though psychologically some people prefer to snowball.
Emergency savings
If you don’t have any debts, then your next priority will be a buffer to ensure you can avoid building any in the future. This could be to cover unexpected one-off costs like new tyres for your car or a plumber call out, through to paying for essentials if you lost your job or were too ill to work.
The general rule here is to save enough cash to pay for your rent or mortgage, bills, food and other essentials for three to six months. These lengths of time are at the more extreme ends of emergencies, but it’d hopefully mean you keep the power on and a roof over your head while look for another job.
If six months seems impossible, you can always aim for three months (or as close as you can), and add to it over time as and when you have more spare cash.
Most people don’t need more than six months for these purposes, though there are exceptions. Freelancers or anyone with uneven income, might find they want access to cash for longer periods – as many found during the pandemic.
Plus, retirees might want up to three years of essential spending saved up. That’s largely so they don’t have to withdraw from pensions during times when the markets are down.
Most if not all of this money should be in easy access accounts. This means you can get the money instantly if you need it. If you do have funds to last you longer than six months you could consider notice accounts (if they pay better rates of interest), or fixed term bonds.
In addition you might want to consider income protection, critical illness cover or life insurance here, especially if you have a family and you’re the main breadwinner. They’ll pay out a lump sum or cover things like your mortgage if the worst happens.
Help to Save
Just a quick shout out here for one specific account that lower earners on Universal Credit should be using alongside their easy access emergency funds.
The Help to Save account lets you save up to £50 a month, and you will earn you a 50% bonus after two years. Here’s more on how Help to Save works.
Match your pension
Next up, make sure you’re paying into your pension. If cashflow is tight you might be tempted to opt out of these, but you’re leaving free money on the table.
First, you get tax relief on payments, so a basic rate taxpayer only adds £80 to have £100 in their pension, while that’s effectively £60 for £100 for a higher rate taxpayer.
Then, there’s more on top as employers have to add more up to a certain level. As standard if you add 8% of your salary, they’ll add 3%. So it’s another £60 on your £100 contribution (which has only cost you £80)
Find out if your employer will match or beat your contribution if you add more – it could be well worth it.
This is for specifically for defined contribution pensions (DC) rather than defined benefit (DB) ones – though overpaying to these DB is something you might want to look at much later on if you have one.
Fill state pension gaps
For those between 50 and the state pension age (currently 66, but moving soon to 67), it’s also worth looking to see if you have any gaps in your National Insurance record. Typically you’ll need 30 to 35 qualifying years to get the full State Pension, and paying to fill missing years can make a big difference later on. You can go back six years.
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Immediate expenses
This is really about regular expenses over the next month. Most of the time it makes sense to pay your bills straight after payday (and sinking funds contributions), then what’s left is what you have to spend that month.
You might not necessarily want to move this to a separate savings account, though most current accounts don’t pay any interest. So, if you do have a decent sum lasting through the month, putting it somewhere that earns some interest could be worth it.
Short term sinking fund
You’re then set to think about planned expenses in the next five years. This is the most typical type of savings account. You might have heard it referred to as a ‘sinking fund’.
This can be really short term, such as money for a birthday in a few months or holiday in the summer, through to bigger expenses you can’t afford right now but know you’ll need or want to buy, such as a new phone or your first home in a few years.
Do not keep this cash in your current account – it’ll increase the chances it’ll disappear into day-to-day spending. Instead, make sure you move it elsewhere. You can even split it up in to multiple accounts or pots, depending on why your saving.
Depending on when you plan to spend this money, you can consider a mix of easy access, notice and fixed term accounts.
You won’t want to invest this money in stocks & shares as there’s a chance the market could fall just as you plan to use the money.
Tax free: savings vs ISAs vs Premium Bonds
Where you put your emergency and sinking funds should in the most part be down to what accounts pay the highest interest rates.
But you will also want to factor in whether you’ll be taxed on your interest. For most, normal savings accounts will be fine thanks to the personal savings allowance (PSA). This is £1,000 of tax-free interest each year for basic rate taxpayers, falling to £500 for those on the higher rate. If you’re earning 4%, that’s just under £26,000 or £13,000 respectively – more than enough for how much people need to hold in cash.
Low earners can increase the tax free allowance on savings interest with the starting rate of savings.
Beyond these, you can save up to £20,000 in a Cash ISA each year (falling to £12,000 from April 2027), and all interest you earn, year after year, will be tax free. However, using the cash version of an ISA limits your ability to use the Stocks & Shares ISA.
You could also consider Premium Bonds. Up to £50,000 can be kept in these and winnings are tax-free. These will generally pay less than other options. However, if you’re additional rate taxpayer you don’t get a PSA and would part with 45% of all interest held elsewhere – in which case Premium Bonds could be good options for your cash savings.
Longer term goals & wealth building
We’re at the top of the pyramid now, and its split in to three core areas, all worth considering.
Most of the time, if you’re saving for something that’s more than five years away, you’ll be better off investing it rather than keeping it in cash.
This includes distant planned expenses, which you’d move into cash around five years before you expect to use the money.
However, this it’s more likely to be for when you have additional cash that you’re putting aside to grow into longer term wealth. Effectively it’s anything over what you need for emergency, immediate and sinking funds.
The logic is that over time, gains are more likely to larger via the stock market than in cash, though as you no doubt know, past performance isn’t an indicator of future results.
Here’s more on how to get started investing.
ISA vs GIA
When you look at investing options, the best place to start is within a Stocks & Shares ISA. Any gains you make from selling the shares or dividends paid out will be tax free forever. This is likely to be worth more than the Cash ISA protection as you’ll probably have had longer for growth.
Remember you can only add £20,000 of new cash to an ISA each financial year, though this allowance resets each year for new contributions.
After this you can keep investing in a General Investment Account (GIA), though you’ll only get a £3,000 Capital Gains allowance and £500 dividend allowance each year before tax is due.
Check out our list of the cheapest ISAs for investments
Extra pension contributions
Alongside investing, you can pay more into your workplace pension. The money you add will still get tax relief, and you can withdraw 25% tax-free. The downside is of course that you can’t access the money until 10 years before you reach state pension age.
Assuming you’ve capped out on the matched proportion from your employer, a Self Invested Personal Pension (Sipp) might work better for you as you’ll have access to more investing options.
Across workplace pensions and Sipps, you can add up to £60,000 a year, or equal to 100% of your earnings. However this limit on contributions includes tax relief and employer additions. You can back date this by four years.
Mortgage overpayments
Though overpaying your mortgage is last on the list, it’s level at the top of the pyramid with investing and pensions. Ultimately it’s your choice which you prioritise, though personally I think a mix makes sense.
The argument against doing this tends to revolve around longer term investing gains, whether ISA or pension based, likely to beat mortgage rates. Similarly, if you can get higher savings rates on cash than your mortgage rate, that will save you more money.
But there are strong reasons to consider clearing your mortgage faster.
First up, if you can increase the equity in your home, it can help you get better deals when you remortgage. This is about moving up the Loan-to-value (LTV) thresholds, which tend to go in 5% increments from 95% to 60%.
Then there’s just the flexibility and peace of mind that comes with becoming mortgage free earlier.
Watch out here though as many mortgages cap annual overpayments at 10% of the total, while there can also be early redemption charges if you clear it early.
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