Should I pay off debt or invest? (or both)

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Interest on your debt? No thanks. Minimum monthly payments? Ugh. Late fees? Thank you, next.

Ahh.. debt. Chances are, you’re likely paying off some form of debt. And if you air that grievance to nearly anyone – you’ll likely find a sympathetic ear as nearly 74%1 of Aussies carry debt. This could come in the form of a student loan, mortgage or (the killer) credit cards.

Not all debt is bad. Debt can often be thought of as ‘good debt’ and ‘bad debt’. Good debt will come about when you borrow money for the purpose of buying an asset that will increase in value or bring in further income. Bad debt on the other hand would likely have arisen due to spending that will not further your financial position.

So, should you throw every spare dollar you have at debt? Or should you start investing and getting onto the mathe-magic of compounding?

Okay, it will depend.

Depend on what?

It will depend on how much debt you have relative to your income and owned assets, as well as the interest rates on your debt.

We generally recommend:

  • you put 20% of your take-home income towards future you. This could go towards:
    • savings
    • investing
    • paying off debt
  • for any debt with a higher interest rate (above 5% or so) you should focus on paying this off before investing or saving. This will likely be your credit cards. If you have existing savings, use this to pay down your high interest debt (you’ll likely be better in the long term).
  • once you’re free from those audacious interest rates you should focus on building an emergency fund which should equal three to six months of your take-home pay but do not stop paying the minimum payments on all the other debt you have as missing these payments can royally mess up your credit score.
  • you focus your efforts on investing once you’ve paid off debt with high interest rates and set up an emergency fund.

But why shouldn’t I pay off all my debt?

I’m so very glad you asked.

It’s all about interest rates.

Credit cards, for example, on average can come with an average interest rate of 16.58%2. On the other hand, HECS (Higher Education Contribution Scheme) debt in Australia is effectively an interest-free loan and indexed to the consumer price index (which does mean the amount goes up every year but no more than inflation (around 1.9%) and you are forced to repay the loan once you reach an income threshold ($45,881 before tax)). As you can see, that’s a huge range of interest you could be paying on varying debt.

As for investing, the interest, historically has given investors positive returns and the interest investments generate generally falls somewhere in the middle of the interest owed on HECS and credit card debt, at least that’s been the case for the Australian sharemarket over time. The Aussie sharemarket has had a long-term positive return (an annual average of 11.8%3) although some years it’s more and some years it’s less and some years it’s negative, but that has been the trend historically.

Generally, we therefore recommend using extra cash to first pay off debt that has interest rate greater than 5% (i.e. greater than the returns you could potentially making on the sharemarket for example) but if you have debt that is less than 5% we would generally recommend you maintain your minimum repayments and then use any extra cash to invest (as in the long run, you’d likely be making more). Why 5%? We believe this is a reasonable benchmark to draw the line between average interest rate of debt and average interest generated by sharemarket.

At the end of the day, any money you’re putting toward debt or investing is a step in the right direction. So, let the math work out which one to focus on first.


3. Perpetual Investments and Bloomberg 1900 to 2019


Knowledge is Power
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Perpetual Private advice and services are provided by Perpetual Trustee Company Limited (PTCo) ABN 42 000 001 007, AFSL 236643.

This information has been prepared by PTCo. It contains general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, who can provide you with the relevant Financial Services Guide, whether the information is suitable for your circumstances. The tax information contained in this document is not tax advice and should not be relied on as such. This information, including any assumptions and conclusions, is not intended to be a comprehensive statement of relevant practice or law that is often complex and can change. To the extent permitted by law, no liability is accepted for any loss or damage because of any reliance on this information.