A few weeks ago, I was engaged in an email chain with one of my readers who asked me whether I thought he should be using his paycheque to pay down debts or to invest in income-producing assets. This sort of sent alarm bells ringing for me, as I’m clearly not a financial advisor, so have to be very careful about how I respond to questions like this. In the end, I decided that I’d take the risk and provide some general advice – the principles of how to make the decision – without going as far as to say ‘Do X or Y’. To help clarify, I’ve copied out part of the reader’s email below;
I’ve recently started a new job as an IT contractor, which comes with a bigger salary than my old role. For the first time in years, I’m earning enough to have £500 in free cash after I’ve paid all my bills. At first, I was just spending this money; you know, drinks and meals out and new suits, but actually, I’ve decided that I want to use it to invest in my future.
After University, I’ve got nearly £10,000 of debt on various credit cards, overdrafts and loans. It’s not as much as some people but it’s always a worry to owe so much money. On the other hand, most of it is at 0% – I’m not paying any interest and never have.
So the thought occurred to me – instead of paying off the debt, why don’t I invest the money – even if I was only getting 1% in a savings account, it would be more valuable than paying off the debt right?
What do you think I should do?
This was a really interesting email for me to receive. I’ve been in a similar situation myself, so can completely follow through the thought process. On the one hand, you’ve been learning about the power of passive income; you’ve got a slightly entrepreneurial/business-like approach to life and are keen to boost your monthly cash flow. On the other hand, you’ve also got this millstone of debt hanging around your neck. You’re not paying any interest, but you’re tired of seeing £100 chunks of money disappear every month to pay down debts from things you did years ago.
In my opinion, having a portfolio of income-producing assets is the key to becoming wealthy. Once your investment income is greater than your expenses, you’ll have achieved that magical thing finance bloggers call financial independence. You know that each day you delay the growth of your portfolio is time wasted in your pursuit of that goal; by paying down debts which are incurring no interest, you’re choosing to sacrifice capital which could otherwise be invested.
In my experience, the accumulation of debt can be a dangerous thing. Sure, you tell yourself that you’ll never miss a payment, or that you’ll always roll the debt onto another 0% card. But what happens when you forget? One misstep and suddenly all that lovely 0% debt rolls onto a 20% rate. That debt load can become a problem if you lose your job, and having too much can impact your credit rating. Perhaps worst of all, the fear of these things can lead to a build-up of stress in your life.
How I look at the ‘Debt vs. Investment’ question
As with all financial decisions, the choice between paying down debts or investing is one which is personal to you. It doesn’t matter what an account, mentor, friend or colleague might advise – you must be comfortable with it. In my case, I try to take the emotion out of the situation and look at the facts.
- What return could I make if I invested as opposed to paying down debts
Ultimately, my use of money is simply as a tool to generate a financial return and in doing so empower myself to give back to society through the ability to fund charitable causes, pay taxes and pay my way in the world. Using this as a starting point, I ask myself – where can I get the greatest ROI (Return on Investment) for each pound I own? If I’ve got a loan on which I pay 10% a year but I can invest in a property deal paying 15%, the property deal has the better return – it’s obviously better to earn 12% than to save myself 10%.
Having said this, my investments don’t usually generate 15% consistently, and most loans charge significantly more than 10%. If the interest rate on the debt looks unlikely to be outperformed by my investments, I’d be better placed paying down the debt.
- On what terms did I take out the credit?
Not all debt is equal. All comes with terms and conditions to which you agree as a borrower. For me, a big consideration is the maturity date of the debt. If I spend £5000 on a credit card at 0% for 18 months, it must be repaid at the end of the 18 months, either with cash from my pocket or with a balance transfer whereby another debt provider clears the balance but I then have to repay them instead.
Whilst it might make sense to chase ROI by investing rather than paying down debts, another consideration for me is portfolio liquidity. For example, if I have to repay £5000 in 18 months, will I have the cash available to so?
Debt can also have a ‘floating’ exchange rate which rises and falls based on the Bank of England Base Rate. For example, I might take on a mortgage charging the Base Rate + 2%. If the BoE raises the Base Rate, my mortgage has suddenly become more expensive to service. As such, if I were investing rather than paying down debts, I’d look at how easy it would be to liquidate those investments to repay debt when it matured, or if it became more expensive to service.
- How much debt does my whole portfolio hold?
When trying to make a decision like this, I take a holistic view of my portfolio. How much debt do I hold in total? How many individual investments do I hold? What is my annual savings rate? Is my pension on target? Personally, I’m comfortable with working with some level of debt – especially if it’s at 0%. Having said this, I recognise that finance can be a stressful issue for a lot of people and as I’m always telling people – creating more stress for yourself is not a smart move! If holding onto debt to make investments will create more stress for you, I’d suggest avoiding it.
Any investment I make before paying down debt will be one which works towards my long-term financial goals. By doing this consistently, I can use the revenue to service 0% debt, reducing my overall risk. I recently read a thread on a personal finance blog about a man who took out a line of credit to buy gold; not metaphorical gold, but real gold coins. When the price of gold fell (yes, it can happen!), he was stuck trying to pay the interest payments after losing his job, whilst being unable to sell the gold to cover the original debt!
By investing in income-producing investments, you can help protect against this risk. It’s also worth bearing in mind that you don’t need to take an ‘all or nothing’ approach with a decision like this – you might choose to use some of the money to pay down debts and the remainder to buy assets. As with most things in life, having a balanced approach is important to long-term success.