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Neither a borrower nor a lender be….

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14/07/2014
Debt - everyone seems to be struggling with it – from the government down. A note issued by peer-to-peer lender Zopa estimates that the average Briton has £4,500 of credit card debts, on which they are typically paying an interest rate of 17.9%*.

According to the lender, 20% of these cardholders are paying off only the minimum each month, which means it could take them up to 17 years to eliminate their debts – that means they will probably pay back more than double the original debt once interest is added in.

Of course, most people’s debts aren’t only confined to nightmarish credit card statements. One of the key reasons why the UK government is reluctant to increase interest rates is concern over whether mortgage holders would be able to service their debts.

Bank of England governor, Mark Carney has said that the “vulnerable position” of family finances means any interest rate increases will be “more limited and more gradual than in the past”.

Households in Britain have a lot of debt and, for many, the debt they face – be it a mortgage, credit card or student loan – is the biggest obstacle to investing. While good financial instincts are to pay off debt as soon as possible, there are ways of balancing your debt with saving and investing.

Three things to think about if you’re struggling to manage your debt obligations and invest:
1. Distinguish between different types of debt
It is important to realise that there are different types of debt and it is important to distinguish between these – with high-interest debt such as credit cards, your best option is to pay these off as quickly as possible before you start to invest.
However, with low-interest debts such as a car loan or mortgage you can still build a portfolio while paying your borrowings down. Remember that, by only paying down debt you will lose time and money in investment terms, and over time your investment might end up being worth more than the money you actually pay back to your lender.

2. The power of compounding
The reason why time is such an important tool is compounding – you want to give your money as much time as possible to build new interest on the interest you’ve already earned. Reinvesting the income you receive from your investments increases the amount of money working for you over the longer term.
Your investments may be small, but they will pay off more debt than investments you make later in life, because there will be more time for these investments to grow and ride out the ebbs and flows of the market.

3. Your mortgage vs your pension
Many argue that you should pay off your mortgage before you invest, as this effectively ensures you a guaranteed return for life.

However, if you are paying a low mortgage rate which many of us may be after five years of low interest rates, does this still make sense? A good investment may yield more than you are paying on your mortgage. It is also worth remembering that inflation will erode your mortgage over time – meaning the final capital repayment will fall in value in real terms.

Ultimately, however, your house should be seen as place to live and not an investment.

If you’re contemplating sacrificing saving into a pension in favour of paying off your mortgage, you should rethink. It makes little sense to avoid contributing to a pension as you will be missing out on the income tax relief from pensions that will compound over the years. If you are a member of a workplace pension scheme you will also miss out on your employer’s contributions.

Last word
You can invest in spite of debt – the important question is whether or not you should – and the answer to this will depend on your individual circumstances. Indeed, many people choose to gear up their investments, using debt as part of their investment strategy to boost returns or reduce tax. But, for many, investing while in debt is like trying to bail out a sinking ship with a coffee cup. Eventually, the ship will sink…
*UK Cards Association Quarterly Market Report Q3 2013;

Maike Currie, Fidelity Personal Investing

 

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