Clear debts first - HG15001

It is generally advised that everyone should invest, especially for retirement, but debts should be cleared first as this will be more profitable.

Whilst investing for retirement or other purposes is usually advised there are times when it is not appropriate. As Why Interest Rate is Lower on Savings than Loans explains, debts are more expensive than the returns available on savings and most sensible investments. So clearing debt should be the first investment.

Cost of Debt is Greater than Savings and Investment Returns

Credit cards and many loans are simply more expensive than sensible investments. If an investment scheme offers promised returns that look too good to be true, they are almost certainly unsustainable.

Most Loans are Short Term, Investing is for the Long Term

Apart from mortgages most loans and other debts are short term, typically five years or so, whilst investment is a long game. As a result borrowed money will need to be repaid before most investments will mature. Repaying the debt from the accrued investment will lose the most profitable period as it is the later years which provide the greatest profit. Alternatively the borrowing will have to be refinanced, if it is even possible, to keep the investment running. This will incur additional fees, effort and uncertainty as to whether a low enough interest will be available.

Borrowing to Invest Does Not Work with Few Exceptions

Long term low cost debts such as mortgages have meant that sensible property investing was just about viable for the careful investor within limits. But borrowing even at low bank loan rates of 8% do not work when sensible investments typically return 11-12.5% and are still volatile over the period of typical bank loan. Bank rates of 10-15% have not been uncommon on many loans in the past.

As an example borrowing £10,000 over 5 years at 8% will require total payments of around £12,500. The £10,000 would yield about 12%, with a good chunk of luck, over that period giving a total return of £17,600 or cash in hand of £5,100.

Instead of paying £2,500 back to the lender, the borrower could became a saver and invest those repayment amounts. At the same 12% and £2,500 per year (£12,500) the investor would have £17,750 cash at the end of five years as they would also have retained the principal. If the investor let the investment run for twenty years it would become nearly £100,000 without further contributions. The borrower could let the £5,100 profit run and it would only be £25,000 after the same period or a around £75,000 if lenders would allow refinancing on similar terms every 5 years.

Both approaches require the same regular cash outlay over the same period but the investment route is several times more profitable. The investor is able to invest £12,500 but the borrower only £10,000 and has many additional costs to be paid out of any profit, interest, bank fees and the like.

Turn Borrowers into Investor – Invest in Clearing Debt

It is clear then that adding debt for investment purposes does not really make sense. For those with credit card or other short term debts the best investment they can make is to clear them as fast as possible. Once that has been done the borrower can become an investor and start investing for the future rather than paying off the past.

If a borrower has £10,000 of credit card debt at a typical interest rate of 17% then to clear that loan over 5 years would cost about £250 per month or £3,000 per year. However if an investor had £3,000 per year it could have made over £21,000 in the same period. So the real cost to such borrowers is the £5,000 they paid out on interest and the £21,000 they missed by having to repay the debt. Or nearly £125,000 in total by not being able to allow it to run for 20 years.

Pleasure of Receiving Interest and Not Paying It

Another benefit is that having no debt feels wonderful – all income can be used productively. No longer is there resentment at the amount of interest being paid, by then any pleasure of the purchase is usually long forgotten. Becoming an investor gives former borrowers a warm glow when they realise that they are receiving, not paying, interest.

There is much to recommend in having “unearned” income.

 

 

 

First appeared on Suite101

 

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