What to do about debt
This is the last of the preparatory episodes before we get into investing proper. We are going to deal with debt and whether you should clear debts before you invest or is it better to keep the two separate?
Debt is a big issue in the UK. Don’t take my word for it though; here are some facts courtesy of The Money Charity
Average credit card debt per household in January 2019 was £2,638 which doesn’t sound too bad. In the last episode the credit card example I used had a £1000 debt being paid off over 2 years. It assumed a £50 a month payment and the balance was cleared after two years. But…a lot of people make the minimum payment each month usually the higher of 3% or £5.
The Money Charity says that the average credit card interest rate in January 2019 was 18.67% which is way above the Bank of England base rate of 0.75%. And if you pay off the average credit card debt making only the minimum payment per month, it will take you 26 years and 7 months
The National Audit Office reported in September 2018 that 8.3m people cannot afford to pay off their debt!
So yes, debt is a big issue for a lot of people. I said in the last episode “avoid credit cards like the plague” and that hasn’t changed. Paying an average of 18.67% interest to buy something is not good for your long term financial health.
Earl Wilson an American journalist once said, ““Today, there are three kinds of people: the have’s, the have-not’s, and the have-not-paid-for-what-they-have’s.”
The question for this episode is, “should you pay off your debt before you invest?” This is clearly not a problem you need to worry about unless you have both debt and money to invest. If you’ve no money to invest, check out the last episode.
Assuming that you do find yourself in the situation of having spare money and debt you may be one of the many people who never stop to consider what to do. Why is that? It probably has a lot to do with the order in which things happen. Most people have debt, such as mortgages, long before they have enough money in the bank to think about investing. The average age for a first time buyer these days is 33 according to the BBC. That means people are saving for deposits and costs of buying a first home until that age. For other people it can be that they rent their first flat and take on debt to furnish it.
When they do finally find that lump sum sitting there, it can be a long while after the mortgage or other debt started and the repayments have become just part of the monthly outgoings. They are almost “out of sight out of mind”. Because of this it is too easy to look at the lump sum in isolation and think about how you’re going to spend it or where you’re going to invest it.
There is an emotional attachment to having money in the bank – more than you need for your emergency fund. It makes you feel wealthy, comfortable. But you really need to consider the debt as well. It’s like two sides of a seesaw, one can lift you up and the other can pull you down. As a very general rule…If you earn more on your investment than you pay for the debt then invest. But there is a lot to consider before you leap in! You need to know how much your debt costs and what returns your investment will give you.
Looking at investment returns, most people start out with a deposit account and these days hold it in an ISA. So how would they be doing? Not so well I’m afraid. The average interest rate on a cash ISA in January 2019 was 0.84%. There is a huge difference between what you pay for debt and what you earn on your savings.
Let’s look at the credit card example. As I mentioned the average credit card is charging 18.67% and the average cash ISA is paying just 0.84%. If you have a credit card debt of £1000 it will cost you £186.70 in interest over two years repaying £50 a month and that is a big “if”.
If you find a spare £1,000 to invest and you pop it in a cash ISA you will receive £16.87 interest over two years. A negative difference of £170. You are worse off because the investment earns far, far less than the credit card debt costs you.
You will already have jumped to the right answer – in this case it is better to pay off the credit card than invest the £1,000 in a cash ISA.
But there is more to it than that. Remember you were paying £50 a month to your credit card. That is money you should save each month. What happens if you invest that £50 a month in the cash ISA? It will be worth £1,210.52 in two years’ time versus the £1016.87 your cash ISA would be worth. So while you may feel you have “lost” the £1,000 in paying off the balance you are actually much better off if you use the monthly savings to replace it.
God this is boring! And if I’m bored then you must certainly be! When I was presenting at conferences I could see the audience and interact. That’s clearly not going to work with a podcast. I used to use humour in my lectures so I reckon that I should give it a try here.
I tried to teach my dog how to dance – it didn’t work out. He’s got two left feet.
The self-deprecation society is opening a branch in my town. I’ve put myself down already.
My knowledge of Greek mythology has always been my Archimedes heel.
Don’t forget you can feedback using the contact page on the site, http://www.poundsshillingsandsense.com
Back to the boring stuff…
We’ve looked at credit card debt, but how does it work for mortgages? The rates are much lower than for credit cards because the lending is secured against your property. The average variable mortgage interest rate in January this year was 4.48% according to the Building Societies Association. Is it worth keeping mortgage debts? As a general rule if you can earn more on your investment than you pay for your debt, you will be better off investing. If your investment earns less than your debt costs pay off your debt. In practice the answer is “it depends”.
There are some types of debt that carry exit fees for early repayment such as fixed rate and discounted mortgages. If you are not sure about your loans then check with your lender. Such fees need to be taken into account in the decision you make and can make a big difference.
Clearly if you are earning 0.84% on a Cash ISA and paying 4.48% on your mortgage then your debt is costing you more than you are earning on your investment. Remember compound interest – the longer the term the greater the impact. An ISA earning 0.84% a year over twenty years will grow by £182.11. How much would you save in interest if you repaid that £1,000 off your mortgage? Halifax has a calculator on their website which works out the benefit of overpaying your mortgage. When you feed the details in the answer it gives is a saving in interest of £1,382 versus the interest earned on your ISA of £182 that’s a big difference.
But that is based on a fairly low rate of return on the ISA. You might be thinking “Hang on matey, you said in the first episode that returns of 7% are achievable at the moment on investments”.
Surely then, it is worth investing if you can get that sort of return? But the answer is again “it depends”.
The 7% return is the growth in the value of the investment before you pay charges to the fund manager and tax on any profit. Those two factors can make a big difference.
Fund management charges can vary hugely from as little as 0.05% a year to well over 2.5%. When you do make a profit the taxman will want to know about it. Investment profits can be charged to income tax, capital gains tax, dividend tax or all three. It is too much to cover in a single episode so I plan to cover it later in the series (unless you write in asking for it to appear sooner!). But for now be aware that ISAs are free of tax on profits made whether that is from growth or income. There are savings income allowances as well and you can find out more here
If you do pay tax it can reduce your returns by 20%, 40% or 45%… or more (higher rates apply in Scotland) after you have paid the charges on the fund. That means for a basic rate taxpayer the amount they receive in their hand on a 7% return could be as low as 3.6% – less than the interest on their mortgage.
So is it ever possible to get a return higher than your mortgage? Yes. A few years ago the government introduced Auto Enrolment pensions in the workplace. From this April you have to pay a 3% contribution, your employer has to pay a further 2%. That means for every £3 you pay in you have already made £2 in profit before charges in tax – that is a 66% increase before you earn any investment returns. Some employers operate pension schemes which are better than Auto Enrolment and you could find that they match your contribution up to a certain level. That is a 100% return before you earn investment returns. When you do enjoy growth on your investment in your pension it is free of tax at source, much like an Individual Savings Account. As if that isn’t good enough, on top of that, your pension contributions receive tax-relief. A basic rate tax payer putting £100 in to a pension only pays £80 out of their pocket – an uplift of 25% before your employer adds to it. There is tax to pay when you take benefits from your pension. Any income you take is taxed at your marginal rate but you can take 25% of the fund free of tax.
Choosing the right investment product can either damage your wealth or turbo-charge it.
There is another factor to consider before you rush out and pour all your money into investments. How long the debt has to run is critical. The shorter the term the loan/debt has to run the more risk there is. To get the 7% returns I mentioned will mean the investments you hold go up and down in value. Riding out those ups and down is much easier over 25 years than 3 years. The last thing you need is to find your investment has plummeted in value just when you need to pay off your loan.
Which provides a neat segue to the next episode, where I will look at investment risk. Or more accurately – investment risks!
To summarise – in general it is better to clear your debt before you invest and to clear the highest interest debt first. But it is not a golden rule – it does depend on the debt and the returns you can make on the investment. If in doubt seek advice from a regulated financial adviser. Click here for the FCA webpage on choosing one.
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Catch you next time.