Learn About Investing
We all know debt is money you owe, but not all debt is the same. Nor is it necessarily a bad thing.
It all depends on the size of the loan and the interest rate you’re paying on it. Your personal circumstances will always be a critical factor.
Before taking on debt, ask yourself the following hard questions - and be honest!
1. Do I really need it?
Are there alternatives, like cutting back on other household expenditures? This one is particularly important if you’re acquiring ‘bad debt’ that gets spent on consumables.
2. How much will it really cost?
Check the interest you’re paying! Tot up the total cost of the loan, including interest and charges. The Annual Percentage Rate (APR) shows the interest rate over a year. Better still, look out for ‘effective APR’, which factors in the effects of compounding. For instance, a £10,000 personal loan at 18% APR over 5 years will see you paying back £15,236 in total. Online calculators can help with the maths.
3. Can I afford it?
Not just ‘can I afford it now?’, but ‘will I be able to afford it if interest rates rise or if my income drops?’ It’s wise to leave yourself some breathing room. In any case, it’s sensible to shop around for the best interest rates and have a plan in place for repaying it.
4. Is it worth the risk?
Some loans may be ‘secured’ against assets you own. This means you may pay lower interest than might otherwise have been the case. The bad news is that your ‘collateral’ asset can be seized and sold by the creditor (who lent you the cash) if you fail to keep up your repayments. For example, with a mortgage, your house can be repossessed by the lending bank if you fall too far behind with your payments.
While there are no hard-and-fast rules, some forms of debt are more likely to make sense than others. Such ‘good debt’ may include mortgages, student loans or loans to start a business. What they are likely to have in common is that they are used to buy:
- something that generates future income, enabling you to service the debt and pay it back in full and/or
- an asset that increases in value
While ‘good debt’ tends to generate benefits in the future, ‘bad debt’ tends to be used to purchase things that get consumed immediately or rapidly lose value. Watch out for:
- Clothes, holidays and cars. Some people justify buying expensive clothes by claiming that ‘it’s an investment’. Unless a new suit scores you a job, it’s not. Holidays are often paid for with credit, but once the tan has faded there’s not much to show for the financial splurge. Cars can be a big financial drain: typically losing 20-30% of their value as soon as you drive them off the forecourt and around 15% a year thereafter.
- Credit cards and payday loans. Three out of five UK adults own a credit card, and they’re a very popular way to pay for goods and services. But if you don’t pay the monthly balance in full, your debt has the potential to spiral upwards. The interest rates on payday loans are in a different league. Their annual percentage rates can be hundreds as times as high as the best credit card deals.
Of course, debt may not be down to frivolous expenditure. For many people it is the only option and used to pay for basic necessities.
Beware commercial ‘debt management’ agencies that charge fees, despite having names that sound like debt charities. Lots of free and confidential help is available, so there’s never any need to pay for services from this type of company.
Compound interest is great when it’s working to your advantage, increasing your savings. But it works the other way too, accelerating debts.
This is because you don’t just pay interest on the original amount borrowed. You also start to pay interest on the interest. This can start to tot up alarmingly.
Assumptions: £1,000 initial loan, 20% APR, no repayments
If you borrow £1000 at 20% annual interest, at the end of the year you’d owe £1200 (£1000 plus £200 interest).
But the next year, the 20% interest is calculated as a proportion of your new, larger total debt (£1200) rather than the original loan (£1000). So now you owe £240 in interest on top of last year’s total of £1200. That’s a total of £1440.
Year on year, the increase in interest gets steeper. If you made no repayments on the loan, at the end of ten years you’d owe nearly £6,200 – more than six times what you borrowed!
Should I repay debt or invest?
The answer lies with the types of debt you have.
Millions of homeowners with debt are also investors. While paying off their mortgage, they are putting money aside for their pension, kids’ education and the like. As such, it’s commonplace for people with debt to invest.
But investing while holding ‘good debt’ may be a very different story from investing while holding ‘bad’ types of debt.
If you have credit card (or other high interest) loans, it is usually best to pay these off before investing. The reason for this is that the interest payments on the debt are likely to outweigh your investment returns.
Long term investors, specifically pension funds, now use predictions of annual returns (after tax) ranging from 2% to 8%. If your loan interest rate (APR) is higher, it may make sense to pay the loan off first. This is because you are likely to save more by paying off debt than you’d gain by investing.
Again, there are no hard-and-fast rules. The reality is that you have to weigh up predicted future investment returns (an unknown) with current debt interest payments (which are known - and if you don’t know, find out).
So you can’t necessarily make the right decision, but you can at least make a rational one. And in some cases that might mean, for example, paying off a mortgage early instead of investing.
If at all possible, avoid spending more than you have coming in. If you start building up debt, your situation is in danger of turning from bad to worse.
Getting by on a low income takes careful organisation – here are a few positive steps you can take to make it easier.
Money Advice Service
How you repay your debts depends on a) what spare income you have b) what assets you can sell and c) your situation.
Debt isn't just a finance issue. It feeds into all elements of your life. So solutions are wide and varied; from cutting interest costs, budgeting, or simply getting free one-on-one debt help.
This charity provides free, independent and impartial advice to people who have debt problems. Free online guides are also available on the website.