Debt gets a bad rap. From an early age, many of us are told that we should avoid debt at all costs, and if we do need it, we should pay it off as soon as possible. That’s not the worst advice out there, particularly when talking about high interest debt, but it doesn’t offer the whole picture.
Like many things in life, the real deal with debt is a lot more nuanced. In some cases, it actually makes a lot of sense to use debt, or limit how much you pay off your existing debt.
It’s definitely not a black and white topic though, which is why we’re going to delve into the specifics in this article.
Before we can get into talking about debt, we need to explain opportunity cost. This is the term that’s used for something you’re missing out on, as a result of doing something else. If you go out for lunch at the pub and you choose the burger, your opportunity cost is everything else on the menu that you could have had instead.
With money, every time you put £1 towards something, that’s £1 you can’t put towards something else.
So if you are considering paying £10,000 off a mortgage or any other form of debt, you need to consider the other options you have. What other choices could you make with that £10,000? Are there any of those options that would make a better overall financial decision?
Once you calculate the opportunity cost for all of the options, you can make the decision on which way to go.
With money, the choices are actually pretty simple. If you have debt, you can either choose to pay that off, or you can choose to invest instead. This means that the opportunity cost has a pretty straightforward formula.
The question is, could you earn more money from an investment than you would save in interest by paying off debt?
Let's look at a simple example. Say your mortgage interest rate is 3%. For every £10,000 you owe to the bank, you’ll be paying £300 in interest each year. Therefore, if you pay £10,000 off your mortgage, you’ll be saving £300 in interest. That means your ‘return’ on that money is therefore £300 because you’re financially better off by that amount.
When you’re looking at your other options, your aim is to see whether you can find something else that gives you a better return than that.
Now it’s not quite that straightforward in real life because of the compounding (snowballing) effect of investment returns, but it gives a good starting point to understand the concepts.
In reality, compounding works on both the debt you owe or the investments you hold. Using the example above, the monthly repayments you’re making will be reducing the principal of your loan. So by paying extra off the loan, you’ll be reducing the interest payments you need to make next year.
When you’ve done that, it means more of your monthly repayment will be going towards the principal and therefore you’ll pay the loan off quicker.
With investments the same thing happens, but the difference is the compounding doesn’t ‘run out’. With a loan, once the loan is paid off, it’s paid off. There’s no further benefit other than the fact you now have more spare cash flow each month to direct somewhere else.
On an investment portfolio, the compounding is scalable over decades. The portfolio can continue to compound for as long as you hold it, making a much larger difference over the long term than saving a year or two off a loan term.
To summarise, one of the easiest ways to weigh up whether you should pay off debt or invest, is to compare the interest rate you’re paying on the debt to the investment return you think you could achieve with the investment.
But not so fast. That’s not the whole story either.
These two options aren’t created equal. Paying off debt will always put you in a better financial position from the moment you do it. That £300 you’ve saved is a guarantee, give or take a little if interest rates change over the year.
Investing is not guaranteed, especially over short periods of time. You need to take this into account when you’re comparing your options. In order to take the risk that comes with investing, you’d expect to get a better return than the interest you could save by paying off debt.
This is often referred to as the ‘risk premium’.
If you could pay off debt at 3%, or you could invest in something that could most likely provide a 3% return over the long term, would you invest? No. There’s no risk premium. You’re not likely to be any better off financially by taking the higher risk option, so it doesn’t make any sense to do it.
What about if you could get 4% on an investment? It’s still a bit of a line call. But 5% or more? Now we’re starting to get some additional benefit for taking some risk with the money.
What you feel is a sufficient risk premium won’t match what other investors think. That’s ok, it’s just about understanding whether it is worth it to you, and which option can meet your financial goals and objectives the best.
But there’s one last concept we need to cover to ensure you’ve got all the information you need to make your decisions.
There are two main types of debt. Bad debt and good debt. Bad debts are high interest loans that have been used to pay for expenses, not to purchase assets. Some of the most common examples of bad debt are credit card balances and personal loans.
These will often have very high interest rates and no security against them. If you have this type of debt, you shouldn’t even consider investing. Pay it off first.
If you’re paying interest of 10%, 15% or maybe even more, there is no investment you can find that could reliably provide you with a return that makes more financial sense than paying down the balance of the loan or credit card.
Good debt, on the other hand, isn’t necessarily as much of an emergency. This is long term debt that has a relatively low interest rate, which is often at or around the rate of inflation. The specific number will change depending on interest rates at the time, but a ballpark figure would be anything under 5%
Good debt is also secured against an asset, such as a property. Because of this, the most common type of good debt is a mortgage. As a guideline, we tend to suggest keeping your good debt at around 30-50% of your total assets.
As long as your good debt is under control, you can start to weigh up whether investing could potentially be a better financial choice than paying extra off the loan. We have a number of tools in our free app that can help with this.
Sometimes it can mean that not paying off your debt is actually the best option for your financial future. That’s not going to be the right decision for everyone, but if you’re prepared to take a little more risk with your money, and you have a long enough time horizon, it’s an alternative that may be worth considering.
If you want to see how much potential you and your spare cash have, we’ve got a unique, free-to-play-with projection, that allows you to see your potential future net worth. Here is a link to our app.