If you have credit card debt or other types of high interest debt it can be a very good idea to pay that of before you invest any of your money. Paying of your debt can decrease your monthly expenses and help you to be able to save and invest more in the future. Paying of high interest debt can often over time have a better affect on your net worth than investing the money. Only when you can get a risk free return that is higher than the interest rate of your debt should you consider investing instead of paying of your debt. If you are not sure about your status and what you should do, you should follow a guide about loans and debts. Eliminating a 15% interest rate from your expenses is worth the same as a 15% return on invested capital. Since there is no risk associated with paying of debt this gives you a high risk free return on your money. Low interested debt on the other hand can be better to keep and pay of at a slower rate. This is due to the fact that it s possible to get a return on investment that is higher than the lower interest rate and investing the money thereby has a positive effect on your net worth. Lets look on a couple of examples.
You have 2000 GBP in Credit Card debt. The interest rate on your debt is 14.00 APR. Your monthly minimum payment is GBP 80. In this scenario you have 1000 in extra money that you can use to invest or pay of your debt.
If you pay of your debt your debt will go down to 1000 GBP. If you keep paying the 80 GBP a month you will be debt free in a little over a year. Once you are debt free you can invest 80 GBP a month that you no longer need to pay to the credit card company. By paying of 1000 GBP of your debt you avoid paying 140 GBP in interest rate during the first year. You save even more over the life time of the loan. You also reduce the time it takes to eliminate the debt decreasing your total interest even more.
This is completely risk free. You know what your payments will be worth regardless of how the market develop.
In this scenario is it only worth investing your money if you can get a return higher than 140 GBP you earn by paying of your debt. It needs to be high enough to warrant the risk associated with an investment that will be affected by the market. It is very hard to find an low risk investment that give a return of more than 14% a year. Even harder to find one that is wort the 17-18% return that would be required to justify even a low risk. In this scenario it is therefore always better to pay of the debt.
In this scenario you do not have any credit card debt or other high interest debt. Your only debt is a house loan. Your house is mortgaged to 70% of its value. This protects you from having to produce extra securities for your loan in case of a drop in house prices. Your house loan is a 30 year loan with a 2.99% interest rate. You owe the bank a total of GBP 270 000.
In this example you also have GBP 1000 to invest.
If you use it to pay of your debt you save GBP 29.9 a year. Your total loan goes down to GBP 269 000. The monthly payments will remain roughly the same for the next 30 years and your extra payment does not significantly affect your total debt. Paying of on the debt will in other words not have a big effect on your economy for the next 30 years.
It is not very hard to find a low risk investment that can give you a higher yield than the 2.99 you pay on your house loan. If the investment give you more than 3% interest rate your net worth will be positively affect if you invest the money rather than paying of your debt. Even if you only get 5% yearly return on investment you will earn an extra GBP 20 in the first year. The affect of the extra 2% will be a lot larger over the 30 years of the loan.
In this scenario you should always invest your money instead of paying of your debt
It is rare that the reality is as simply as these scenarios. It is common that you will have debts of different kinds which makes the scenario more complex. In this case it can help to look and each and every one of your debt individually to see if they are worth paying of before you invest or not. It should not take you very long to figure out which debt you should keep and which you should pay of before you start investing.
It can be a good idea to establish an emergency found before you start considering investing or paying of your debt.
Once you know which debts are worth paying of before you start investing you should figure out in which order you should pay of the debt.
Pay your debts in order of interest rate
The financially best way of paying of your debt is to pay them of in a descending order starting with the loan with the highest interest rate. Start by paying of the loan with the highest interest rate first and then the loan with second highest interest rate and so on. Focus all your energy on the loan you want to eliminate and only make the minimum payment on the rest. This is the most effective way to pay of your loans and provided you keep paying the same amount each month this is the quickest way to become debt free. (or at least to be rid of the debt that is worth eliminating) A problem with this method is that it can be hard to motivate oneself to keep saving money and paying of the debt if the debt with the highest rate is large and take a long time to pay off. In this case a better option can be to use the snowball method.
Pay of your debts using the snowball method
The Snowball method is a controversial method of paying of your debt that has a lot of supporters. The snowball method focus on human nature and is designed to keep you motivated to pay of your debt. It is not the most efficient way of paying of your debt. If you want to use the snowball method you should order the debts you want to pay in order of size. You then start by paying of the smallest loan regardless of interest rate. This allow you to see quick result as you quickly can eliminate your smallest debt. Once the smallest loan is paid of you move on to the second smallest and so on. This method allows you to see quick results as your eliminate the smaller debts and can help motivate you to keep saving and eliminate all your debt.
Paying of your debt in order of interest rate is more efficient and will allow you to eliminate all your debt quicker. However if you know that you find it hard to motivate yourself to pay of your debt then the snowball method can be a better option.
Getting rid of your high interest debt will help you live a richer life and invest more in the future regardless of which method you decide to use to pay of your debt.