Are you tossing up between the goal of investing and building your wealth and paying down your current levels of debt? The following article will outline some strategies to assist you in determining which course of action to take as well as the associated benefits, costs and risks that should be considered by all investors.
Australian Household debt has steadily increased over the past three decades as a result of the unrelenting desire of Aussies to own their own homes as well as the accumulation of other debts including car loans and credit cards.
The most recent data from The Organisation for Economic Co-operation and Development (OECD), revealed the ratio of Australian household debt to net disposable income is currently 217% – meaning the average household owes twice what it makes in a year.
There are risks and benefits associated with either objective and so in short, the answer to this question is that it depends.
Good debt vs bad debt
It is important to distinguish between good and bad debt because not all debt will be the latter. Good debt refers to the debt associated with borrowing money for the purpose of purchasing an asset that is likely to increase in value over time or produce an income, such as an investment property. Conversely, bad debt is often associated with spending outside of your means which will not assist your financial position in the future.
Debt vs investing
You do not necessarily need to decide between reducing your debt or investing. It is possible to establish a budgeting strategy and approach to your financial needs that enables you to both invest according to your goals as well as pay off your debt.
In saying this, there are many benefits in paying off debt including lowering your level of risk and reducing your financial stress. It is important to be across all of your outstanding debt including home loans, personal loans as well as credit card and education loans. Below are some key considerations that should be accounted for when establishing a strategy that allows you to meet both of these objectives. The effectiveness of these strategies is ultimately contingent on the debt you hold relative to your income and owned assets as well as the interest rates associated with your debt.
Rule of thumb
It is generally recommended to put 20% of your take-home income towards your future goals which could be any of the following:
- Paying off debt
For debt with an interest rate that exceeds 5%, it may be advantageous for this to be paid off prior to investing. This can be paid off using existing savings that you may have available to you. Alternatively, you may wish to allocate a set amount of your income each payday to decreasing this high-interest debt as you are likely to be better off in the long term. Whether this approach is appropriate for you will depend on your overall goals as well as your cash flow position and therefore it is important to weigh up the costs, benefits and risks prior to making any financial decisions.
It is also important to note that you should continue to pay off the minimum payments required on your debts as failing to meet these as they fall due can have disastrous implications on your credit score.
One last thing to check off before refining your debt and investing strategy is to ensure that you have established an emergency fund. This should be equal to approximately three to six months of your income which can be used for any unexpected expenses or emergencies that may arise.
Now that you have paid or are paying down your high-interest debt and have set yourself up with a cash reserve you can consider balancing both paying down your remaining debts as well as building your wealth for the future.
One of the most critical ingredients in balancing these two financial goals is the interest rates associated with your different debts. Interest rates vary greatly depending on the kind of debt you hold. Credit card debt can often come with interest rates of 14-24.99%, however, student loans such as HECS are effectively an interest-free loan indexed to inflation. Hence, there is a varying range of interest that could be payable on your outstanding loans.
Investing on the other hand has the potential to grow and build up your wealth over the long term. The Australian share market has an average annual return of 11.8% with the S&P500 providing shareholders with an average rate of return of 13.5% for the last 10 years. Therefore, investing is likely to put you ahead compared to keeping the money in cash to pay down your debts.
However, it is important to remember that this may not be the case every year and you may experience a market downturn and thus a decrease in the value of your assets. Investors should note that losses are only realised when assets are sold and that risk is measured in time, and hence continuing to hold your assets over the long term will see a reduction in the impacts of market volatility on your investments. The growth of your wealth will ultimately be contingent upon how much and how regularly you invest as well as your risk tolerance and investment time horizon. If you would like assistance with your current investment strategy, click here to organise a complimentary 20-minute phone call with an EPG Wealth adviser.
Therefore, the answer to the question of whether you should pay off your debt or invest is relatively simple but will depend on a few key factors:
- Consider whether pay off any debt with an interest rate of 5% or higher is a suitable and feasible approach for you contingent on your goals and cash flow position – 5% is a reasonable benchmark between the average rate of debt and the average returns generated by the share market
- Establish an emergency fund with three to six months’ worth of living expenses
- Continue to meet your monthly repayments for your remaining debts
- With your remaining savings invest in asset classes that reflect the level of risk you wish to bear as well as your investment time horizon
If you would like further guidance on ways to pay down your debts as well as boost your current investment strategy, please click the link to organise a complimentary 20-minute phone call with an EPG Wealth adviser.