When you start investing, one of the first decisions you need to make is where to put your first spare pound. When money is tight, making the right decision can be very important. What path you take isn’t just maths, but also risk, stress and psychology. I’ll work through all of that so you know what path to take.
Why this question matters so much
It can be very tempting to dive right into investing, but getting a 7% return while paying 20% on your credit card is going to give you an almost guaranteed loss. The image is filling up a bath with the plug out – you may feel like you’re finally getting somewhere, but it’s pouring out of the bottom faster than you can add it at the top.
The other way is dangerous too. I lost years of compound interest in my investments when I paid down all my debt due to an interest rate rise. If I instead had a low cost fix on my mortgage, I could have had some fantastic returns as the stock market soared in the decade after.
Not all debt is equal
Treating debt as equal is unhelpful. Some debts are like a fire in the corner of your house, ignore them and they’ll burn the place down leaving you penniless. Others that are like a small bonfire at the end of your garden that are not going to give you any trouble any time soon.
High interest debt (8%+) e.g. credit cards, overdrafts and personal loans cost you more than you can ever earn from investing. These should be cleared before you start investing at any serious scale. Every pound you pay off a 20% interest debt is a guaranteed 20% investment return; you won’t beat that investing. Even if you find a 30% return investment, after factoring in the risk of that investment you’re still better off paying down the debt.
Medium interest debt (5-8%) e.g. student loans, how you treat them really depends on your risk tolerance. If debt stresses you out, move them to the high interest rate category, if you’re more comfortable and your overall debt level is manageable, treat them as low interest. UK student loans are a special case I’ll cover in their own post, but paying the minimum on those is usually fine.
Low interest debt (<5%) e.g. mortgages and car finance are usually cheaper than the amount you can earn through investing, and often fixed for a long period. It is usually worth paying these down over time to de-risk, but investing alongside these can actually be a good idea, especially if you know the interest rate won’t increase.
The emergency fund comes before both
After years of squeezed budgets, you get a promotion or a pay rise, and it’s tempting to start investing and planning to make your fortune. Unfortunately, three months later there’s a recession, your shares crash, you lose your job and suddenly you’re selling all your investments at a loss.
The emergency fund of three to six months essential expenses, calculated properly for your situation, is necessary before you start investing full speed. I agree with Dave Ramsey on this one; starting with a small amount stops the smaller crises from blowing up your plan. You can then take advantage of the high-return wins before fully funding your emergency fund.
What most people should do
For those of you who love a framework, here is the step by step that works for most people:
- Minimum emergency fund: £1,000 in easy access savings to cope with most crises
- Employer pension match: a pension employer match can be an instant 100% return. This is usually the best return you can get on your money, unless the high interest debt is going to cause you a crisis.
- High interest debt: anything 8% and more you won’t manage to get more from investing, and it will take some stress and anxiety out of your finances
- Full emergency fund: 3-6 months of expenses as a cushion against future crises
- Invest: open a Stocks and Shares ISA with a well-diversified fund. Even small amounts will start to add up over time.
- Lower interest debt: keep these ticking along with the standard payments; make sure they will get paid off on a sensible timeframe
Steps 1-3 need doing in order, whereas 4-6 can have some more overlapping; it’s more a priority order. It’s more important to fill your emergency fund than invest, but that can just mean you put more money to the emergency fund than to investing until the emergency fund has reached its goal.
Should you invest with debt?
The framework above keeps low interest debt running at minimum payments while you start investing. Some people prefer to clear all of their debt before they start investing instead. Both approaches have merit, and the right choice is usually down to your mindset.
Reasons to keep some low-interest debt while investing:
- Habits: it’s hard to get into the investing habit, and by the time you’ve paid off the debt your habits will be very risk-averse. Getting into the habit while paying down debt will make you more likely to continue.
- Compound interest: A pound invested in your twenties is worth much more than a pound invested in your fifties. Investing small amounts when you’re younger can help take the pressure off needing to save aggressively in your fifties.
There are some good reasons to pay all your debt off first too:
- Stress: Having debt long term can be genuinely bad for your health.
- Anxiety: Worrying about your debt levels can cause you issues with your sleep, your relationships and your general wellbeing.
- Freedom: Having no debt can give you the mental clarity to invest confidently, and even to be more capable at your day job.
If the debt is causing you stress and lost sleep, you’re probably better paying it off. If you’ve just got a low interest mortgage that’s fixed for a long time and it’s not bothering you, you can leave it at minimum payments.
The debt-free mindset change
Clearing all of your debt brings you freedom, but it may change your mindset. When we paid off our mortgage, there was a clear drop in our career and income motivation. We reduced our work hours, moved to less demanding jobs and went for fewer promotions.
Our lives are better and we have a better family life, but our wealth is growing more slowly than if we had a mortgage but more investments. I prefer how we’re living but it’s a potential downside if you want to maximise wealth, so it’s something to consider before you decide to pay off all of your debt before investing.
Maintaining debt to improve your earning drive can be addictive, and counterproductive. It’s easy to think ‘I can move into my dream home now and the extra debt will drive me to more income’. Before you know it, your property expenses (heating, maintenance and taxes) have doubled before your investments can support them.
You’ll find your stress has gone up and your life options reduced. You need to work a job you hate and loads of overtime just to keep your head above water, and you never get to spend time in your dream home or with the family who live there. Paying off all your debt may reduce your income potential if you let it, but in my opinion the balance is worth it.
You don’t need a hard and fast rule. Start building an emergency fund. As that gets meaningful, start paying off your high interest debt. When you’re past that start investing and let your lower interest debt tick along with minimum payments. You don’t need to complete one before you start the next. Do what makes you comfortable, and make sure all are covered.