What to do about debt

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 but…

The average total debt per UK household in January 2019 was £59,409

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 5 months! In the last episode the example I used had a £1000 debt being paid off over 2 years – but that assumed a £50 a month payment.

THE UK’S TOTAL INTEREST PAYMENTS AVERAGE OF £140 MILLION PER DAY.

Yes, debt is a big issue for most 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 and 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.”

So how were your savings doing? 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.

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. When they do finally find that lump sum sitting there, it is a long while after the mortgage 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 life you up and the other can pull you down

Let’s look at the credit card example. As I just 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. If you find a spare £1,000 you will earn £16.87 over two years. A negative difference of £170.

You will already have leapt 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 the £50 a month in the cash ISA? It will be worth £1,210.52 in two years’ time but you will lose the interest you would have earned on the lump sum of £1000 of £16.87. That is still a positive difference of £193.65.

How does it work for mortgages – the rates are much lower than for credit cards because the lending is secured against your house. 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. The answer it gives is a saving in interest of £1,382 versus the interest earned on your ISA of £182 that is a big difference.

But that is based on a fairly low rate of return on the ISA. You might remember I 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? 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. Fund management charges can vary hugely from as little as 0.05% a year to over 2.5%. Tax could reduce your returns by 20%, 40% or 45% (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. How long the debt has to run is also 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 5 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 rather conveniently leads to the next episode which is all about risk.

Just to summarise – in general it is better to clear your debt before you invest. 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.