Is debt good or bad?
“Too many people spend money they haven’t earned, to buy things they don’t want, to impress people that they don’t like.”
We have a love hate relationship with debt. Getting a mortgage to buy your dream house is a cause for celebration! Getting made redundant and wondering how to pay for said mortgage, not so fun. Getting a new car on finance, yay!! Still paying 500 pounds a month 5 years later, not so fun. Buying Christmas presents on your credit card is making people happy!! Paying it it off for the next few months instead of saving for the summer holiday… you get the point.
Learn: This will sound like a lecture (and it is) but I want to make clear from the beginning that high interest debt is the enemy of healthy personal finances long term, and therefore to your ability to stop worrying about your finances and getting on with your life. By the accumulating interest on your purchases you end up paying way, way, more for an item than what it said on the price tag. You will also keep paying for the item for a long time, almost always long after you have stopped enjoying it. Take that sofa that you got, where you didn’t have to pay anything for the first 6 month, but then it ended up being a drag on your finances for the next three years, and by that time the sofa had stains, was getting a bit lumpy and you had started dreaming of a new sofa anyway. Not the way to get the most out of life.
But some debt is good right? How can I ever buy a house without a mortgage, it’s not like I can save up all those hundreds of thousands of pounds! I wouldn’t go so far as to say that there are any “good debt” but there is debt that can be helpful, like most mortgages. This is a kind of debt that will not have very high interest rates, and when what you bought for it usually keeps, or even increases in value. Like a house. Rather than be worth a lot less once it’s paid off, like a sofa, or a car.
So what is a high interest rate? Aren’t interest rates kind of low now a days anyway? Let’s look at it this way: If you invested your money in a simple global index fund (not to worry - I will cover this topic in a future post) your average investment return would be 8%. Inflation would make away with 3% of that leaving you with a 5% return.
The most common kind of high interest debt (often around 20% rather than 5%) are credit card debt, car loans and other short term (buy now pay later) loans and pay day loans. These loans will never ever serve you and will always undermine your goal for healthy personal finances.
Pay them off now. As quick as you can.
Start with the one with the highest interest rate and work your way down. As long as you have these loans don’t save, don’t invest, and I would even urge you to temporarily cut down on your spending (no takeaways for two months, or six) to get these loans paid off. If you don’t, you will continue to give away your hard earned money for absolutely nothing. The habit to buy now and pay later stops now. Don’t feel bad about the decisions made in the past, you had your reasons but now you know better and can start on a new path.
So, what debt can I keep? If you have debt that’s just below 5% I would say that it is up to you if you pay it off early or keep to the regular payment schedule. For debt lower than 5% you don’t need to pay it off early, just follow your pre-arranged re-payment schedule on one condition – that you invest the money instead. If you just use the money for extra spending, you will pay interest on your loan and not gain anything by it, but if you invest the money, you will actually get paid for it and as, on average, what you will get paid is more than you are paying in interest, you will get out ahead.
I personally carry two types of debt, the first one being my mortgage that I have together with my partner. Interest rates have been very low over the past decade and there are no signs that this is about to change soon. Our current interest rate is below 1.5% over 5 years, well below the 5% threshold, which is why we’re currently not working to pay down this debt any quicker than the agreed payment term, but chose to instead invest that extra money. However, with 23 years left on my mortgage, it’s highly likely that it will go up at some point before the mortgage is paid off. If this happens, I will consider it a change in circumstances and review my budget, and how I manage this debt, accordingly.
My second debt is my student loan. Growing up in Sweden I had access to a very beneficial student loan that I’m paying off over a number of years. The interest rate on this loan changes annually and currently has the extremely low interest rate of 0.3%. My student loan is a lot smaller than my mortgage, and I have paid back so much of it that I could pay it off today with the money I currently have in the bank. However, because the interest is so low, I choose not to pay it back but to instead invest the money.
To really get a feel for what the interest rate can do over time, let’s say that I have £15 000 pounds that I have saved up and now I have a few options:
Pay off my student loan
Pay off (part of) my mortgage
Invest in low cost broad index funds
Pay off my credit card bill
The below table shows that £15 000 pounds would be worth in 15 years depending on the interest rate.
Compound interest can really be your biggest asset or your greatest liability, £15 000 pounds in credit card debt would grow to £300 000 in 15 year if not paid off!
Paying off my student loan or mortgage (rather than spending the money) wouldn’t be a bad decision as it would still increase the value I got for those 15 000 over 15 years, however if I invested it in an index fund instead, I could have triple the amount of money that I would if I paid off my student loan. If I have credit card debt however, none of the other options would help me in any way and the only option I can take is paying off my credit card debt.
In summary: Debt can be good if the interest is low, and what you bought with it increases in value (house, education) but is always bad if the interest is high and the item you bought will go down in value (car, sofa, electronics).
Plan: This is when you need to look at your individual circumstances and figure out what is right for you. If you have bad debt, review your budget and see how you can pay it off as quickly as possible. It’s really worth making some sacrifices to pay off your high debt quickly as it will quickly run away with you and you will keep giving away your hard earned money and get nothing in return.
If you don’t have any bad debt (well done!!) or once you have paid it off (big congratulations!), use the 5% rule of thumb to decide if you are best of paying down the debt as quickly as possible or sticking with the standard repayments and invest instead. Also consider what you are borrowing for, if it’s an item that decreases in value, you may be better off paying up front rather than in installments even with a low interest rate.
As an example, when we moved into our current house we were buying a new matrass to our bed. Because it’s expensive to move house, Mr. Habitista convinced me that we should pay for the mattress over 6 months, which we could do with 0% interest. Mathematically he was correct, as we didn’t pay any interest it was a good idea to pay it off in installments, but emotionally I wasn’t very happy 5 months down the road still paying for, what was no longer a new, matrass and I was very happy to see the back of those payments after 6 months!
Systemise: Direct debits are your friends when it comes to any credit cards you do chose to use, for their rewards, payment protection etc. Set up a direct debit to pay the card in full every month and never deviate from this process. If you can’t pay it off in full every month you shouldn’t use credit cards. Really, you shouldn’t.
For other debt, I still strongly recommend to pay off the debt as there is always a risk to not owning something outright. Even if mathematically, it may more sense to invest the money there is always a risk when not owning something outright, and remember, your home may be repossessed by the bank if for some reason you can’t make the payments. You can do it at a slower pace though. if you have a 25 year mortgage at 1.5%, please feel free to pay it down at that pace, as long as you do invest the rest.
Review: Keep an eye on your payments, and each time you consider taking out a new loan or credit card, review your options using these guidelines and you will be in a good position! It’s also important to remember that interest rates change over time, so even if your mortgage has a low interest rate now, that may not always be the case and you may need to adjust your strategy.
It’s very tough digging yourself out of a whole of debt, but the mechanics are simple, and once it is done, it is a simple task to stay away from consumer debt making sure that your personal finances can work for you rather than against you!