Human psychology is a fascinating Pandora’s Box. As a general rule, we are all convinced we are rational and take logical decisions based on the pros and cons of choices in front of us. Unfortunately, every in-depth study on the subject suggests this is not the case. We often even completely overlook some choices just because we are not familiar of thinking of them in a particular context.
We usually don’t think of paying down debt as an ‘investment’. An investment, as most of us tend to define it, is something we put money into in the hope of getting more back. On the understanding there is an element of risk involved and it’s possible to lose money. But it’s forward-thinking action. Paying down debt is going back and cleaning up. Sometimes unfortunately necessary, but an investment?
The Cambridge Dictionary defines an investment as:
“The act of putting money, effort, time, etc. into something to make a profit or get an advantage, or the money, effort, time, etc. used to do this”.
If we put the focus on “putting money into something to get an advantage”, there’s a valid argument paying down debt could, in the right circumstances, be more likely to lead to a greater advantage than putting the same money into something we’d naturally consider an ‘investment’.
Let’s take a closer look:
The Case For Investing In Paying Down Debt
Almost all of us have some form of debt. For some it will just be a mortgage. For many more debt will also include things like student loans and some balance on a credit card(s). The burden and kind of debt we might have varies. And it’s in that variation that the math can mean that paying down the debt could be the healthiest thing to do for our long term financial health.
But many of us, used to the idea investing in funds, shares etc. or saving is the best thing for the health of our personal finances, will choose not to tackle our debt at the earliest opportunity. So we leave it building up interest.
Investment Returns vs. Debt Interest
Over the 10 years between 2009 and 2018, London Stock Exchange data shows the FTSE 100 index has provided investors with an average annual return, dividends re-invested, of 8.8%. That can be considered a ‘benchmark’ for the average medium-risk pension fund before fees. Of course, there’s no guarantee those returns will be repeated in the future but it offers a guideline.
But life can be uncertain – ‘best laid plans’ and all that. When it comes to investing, that is particularly relevant and it makes sense to err on the side of caution. Downgrading expected investment returns to an annual 5% or so is safer, if still not guaranteed.
Savings accounts, at current interest rates, generally offer less than 2% interest. Sometimes it can reach 5% but for a very limited time period and usually up to a ceiling of a few thousand pounds.
So when the math is set aside from how we are often used to thinking about investing, sometimes the answer to how to use of any money left at the end of the month becomes relatively straightforward.
If you hold debt that commands an interest rate of higher than around 5% per annum, you should seriously think about paying down that debt. Is it worth taking the optimistic risk traditional investments will earn more than the interest your debt is racking up?
Low interest debt like that most mortgages represent usually won’t cost you more than you might conservatively expect to make from a pension fund investment over the long term. There is a solid financial case to pay your instalments and invest cash left over. Most other kinds of debt come with higher interest rates. The long term financial rationale is often to pay that down first. Then invest.
Photo - Debbie Hudson