But what happens when debt is no longer so expensive?

Since March 2009, the Bank Rate (set by the Bank of England Monetary Policy Committee) has been at a historic low of 0.5%. Interest rates associated with debts and savings have generally followed suit in a downwards direction. Does it still make sense to pay off debt?

What is the alternative to debt repayment?

If you have spare cash then the alternative to paying off your debts might be to save it, invest it or spend it. Assuming you want to build your wealth rather than splash your cash on the High Street, the attractiveness of the save/invest option will depend on the return you hope to get and the tax treatment of that return.

Cautious people who are not prepared to accept risk to their money will probably want to stick with cash, and in the current environment that means a very low return. Savings rates are generally a lot lower than the interest charges on debts. The average instant access savings account was paying just 0.72% in August.

If you are more adventurous then even investing money is likely to result in lower than usual returns in this low-interest, low-inflation world.

Higher rate income tax payers have a greater hurdle when it comes to getting a better return on their savings than the cost of their debt. Even basic rate income tax payers have to factor in the cost of 20% income tax on their savings interest.

If you do utilise your annual Individual Savings Account (ISA) allowance to shelter your savings interest from income tax, you might not be in a much better position. During August the average cash ISA offered a measly 0.41%, down from a not much more inspiring 0.42% in July. It used to be the case that cash in an ISA would always beat cash in an ordinary savings account when it came to the interest rates on offer. Sadly this is no longer the case, at least for the time being.

A real life example

My own financial review last week, the first I have done for myself since the global financial turmoil of last autumn, revealed some useful figures for a real life example of savings versus debt repayment. For privacy and data security reasons, I’m not sharing the names of providers or specific amounts here, but the interest rates are real.

I was a bit disappointed to discover that the interest rate on my savings account had fallen to 0.1% gross. When I opened this savings account several years ago it was paying a market leading rate, which was maintained for several years, only to fall away dramatically when the Bank Rate started to get slashed.

As a higher rate taxpayer, the net interest on my savings was therefore 0.06%. Fortunately for the bank I opted to receive my statements electronically rather than via the post, or the cost of stamps each year would probably be higher than the interest they were paying!

For the most part, the interest rate being charged on my mortgage had fallen dramatically as well. It’s a Bank Rate tracker + 0.14%, so the interest rate is currently 0.64%, at least until the initial term runs out at the end of this year. After that it becomes Bank Rate + 0.99% for the remaining term, so 1.49% assuming interest rates don’t go up before then.

I also have a small further advance on my mortgage, with a less attractive interest rate as it was only taken out last year. This is charged at a Standard Variable Rate of 4.99%. The higher interest rate means it is a no-brainer as to where I should focus my future financial resources, even though this bit of the mortgage debt is much smaller than the main part.

In fact, in order to win with my cash in savings, I would need to find a gross interest rate of 8.32% (or gross interest of 4.99% within a cash ISA). With the Bank Rate at 0.5%, three month Sterling LIBOR not much higher and a banking sector desperate to boost their balance sheets, that’s not going to happen any time soon.

So, along with finding a more competitive interest rate for my savings, this analysis has shown me the real benefit of paying off debt rather than adding to my savings account over the next twelve months.

What about existing savings?

In addition to allocating future surplus income to debt repayment, there is also a strong argument for using existing savings to repay debt. On a pure financial basis, this would make sense. The net return on my savings (money set aside for my tax bill and an emergency fund) is beaten into submission by the cost of the further advance on my mortgage.

The only thing holding me back from doing this is the lack of flexibility it would create. Pre-credit crunch, it would have been a reasonably easy decision. I could have allocated savings (certainly the emergency fund) to mortgage repayment, safe in the knowledge that I could have accessed the cash again in the event of a real emergency. Today I am confident I could not.

Put simply, the availability and cost of new credit simply doesn’t make this course of action stack up today. I could use my emergency fund to pay off a bit more of the mortgage and I would be quids in immediately in terms of interest earned versus interest charges suffered. But if my boiler exploded or the engine fell out of my car, I would be at the mercy of bank lending policies.

Although the credit limit on my credit card has been maintained since the start of the crunch, there is no guarantee that this will not be reduced in the future at the whim of an increasingly desperate bank.

Two decisions at play

There are two dimensions to this decision – the financials and the emotions. From a pure financial perspective, debt repayment prioritised over savings continues to make sense. Debt costs are generally still much higher than net savings rates.

The emotional angle is what can make this a more challenging decision.

It can feel like a very risky move to take money from existing cash holdings and use them to repay debt, placing that cash beyond easy reach if you need it again in the future. In that case you might consider the extra cost of debt over the net return from savings to be the price you are willing to pay to retain access to your cash. There is nothing wrong with that, but make sure you understand what this course of action is costing you.

Martin Bamford is site editor of BrilliantWithMoney and a Chartered Financial Planner at Informed Choice.

This ‘rainy day’ money is your financial safety net should you lose your job or have an unexpected bill to pay. It is the cash cushion that keeps you out of debt (and under your roof) when things go wrong financially. It is pretty important to have.

But how do you actually create this magical emergency fund? What are the steps you need to follow to put one in place?

Work out what you need

The first step in building an emergency fund is to work out what you need. Having a specific target to reach makes it easier to get there, plus you will know when you have reached it!

Your monthly household budget is a great starting point for this. Look through the list of everything you spend each month and then draw a red line through the items you could live without. What you are left with is your committed expenditure. In case of a dire financial emergency, this is the stuff you would have to keep paying.

Once you know this figure, you can easily see for how long your existing savings would last if your income stopped tomorrow. Make a note of this. Would it be a day, a week, a month or longer?

Your emergency fund target then becomes a multiple of your committed expenditure, less any existing savings you have earmarked for the purpose of an emergency. There are no hard rules when it comes to what this multiple should be. Whether you pick three months, six months or a completely different figure is up to you. What is important is that you pick a number and work towards it.

Work out where to put it

You will need a good home for your emergency fund, and ‘under the mattress’ probably isn’t the right answer! The most common place for an emergency fund is a savings account with a bank or building society. Assuming your savings with that institution do not exceed the £50,000 limit of the Financial Services Compensation Scheme (FSCS), you can sleep easily at night knowing that your money is completely safe.

The returns you get on the cash in your emergency fund are less important that the financial security of that money and knowing you can get access in the event of a real emergency. Interest rates on savings are really low right now, so shop around to get the best deal you can and keep the interest rate under review.

There are conflicting thoughts on whether or not to opt for a fixed rate savings account for an emergency fund. On the one hand, your money should be readily accessible. On the other, you should not need to access this money unless there was a real financial emergency. Putting the financial barrier of the loss of some interest between you and your emergency fund can make real sense for this reason.

Get building

Once you have your target amount and you have a suitable home for your emergency fund, get building. Unless you have a lot of disposable income to hand it will take time to build your emergency fund from scratch, but the sooner you start the sooner you will reach your goal.

Factor your savings towards an emergency fund each month into your household budget and monitor your progress towards the target amount. Depending on how you prioritise the existence of an emergency fund, you may want to put other financial priorities, such as saving for your retirement, on hold temporarily until your emergency fund is created.

Whatever you do, have a plan and make sure it is documented. Creating an emergency fund (if you do not already have one) should form an integral part of your written Financial Plan and it should be something you review on a regular basis.

Leave it alone!

Once you have built your emergency fund, you need to resist the temptation to dip into it for anything less than a real financial emergency. It helps here to write down the possible reasons for accessing this cash. If your ‘emergency’ doesn’t appear on your list, you cannot touch the money.

The only exception to this ‘leave it alone’ rule is to include your emergency fund in your annual financial review, to make sure it remains at an appropriate level and is earning a competitive rate of interest.

Martin Bamford is site editor of BrilliantWithMoney and a Chartered Financial Planner at Informed Choice.