This is among the most frequently asked questions – people want to know if they should invest or pay off their debt first. Both these options are noble and equally important, but to get to the answer, you have to do a comparison of the benefits of each.
Some of the benefits of paying off debt:
- Debt costs money: The average interest rate on revolving debt is around a whopping 21%! And unfortunately, you will not earn the same interest rate in any savings account at the moment, so you are effectively losing money.
- Debt leaves you vulnerable to a financial crisis: If you lose your job, how will you pay off your debt?
- Debt causes anxiety and stress: Carrying large consumer debt causes stress; for most people, paying it off can reduce that.
- Beat inflation: Over time, money loses its purchasing power, investing ensures that you beat inflation.
- Earn compound interest over time: The effects of compound interest are undeniable, but you have to free up cash by paying off debt so you can start investing.
- Reach long-term financial goals – that is retirement: So, whether you have some extra cash in your budget, you are expecting a cash windfall in a form of a bonus or you are getting a salary increase, you should focus on the following:
STEP 1: BUILD AN EMERGENCY FUND
Have a minimum of R15 000 in a highly liquid account to begin with.
Having an emergency fund provides you with an immediate peace of mind that should anything happen, you do have a cushion.
A survey done by Budget Insurance found that if an emergency occurred – which warranted an amount of R10 000 – at least 26% of South Africans would need to borrow more money from friends or family, and 11% would take out a loan to cover the balance.
A further 7% said they would cover the emergency using credit.
That is why building an emergency fund is so important, because if you do not have it, you might end up having to draw money from the very debt you are trying to pay off.
STEP 2: PAY OFF YOUR DEBT
The debt you do not want to have is revolving, unsecured debt such as credit card, an overdraft and personal loans.
There are two methods in which you can pay off debt. The first and most highly recommended one is to pay off the debt with the highest interest rate first as it is your most expensive debt.
Alternatively, you can use the snowball debt repayment method. The snowball method allows you pay off the debt starting with the smallest balances first, while paying the minimum payment on larger debts.
Once the smallest debt is paid off, you redirect those funds to the next smallest debt, until all debt is paid off. Although this method does not take into consideration the interest rate, it has a positive psychological benefit. When you realise that you have squashed one debt, it gives you the motivation to keep on going.
Remember, with any debt repayment strategy you have to keep on paying the minimum payment towards all the different debt, because if you do not do that, it will negatively impact on your credit score. Another strategy you should be taking advantage of is, when there is an interest rate cut, like we’ve had at the Reserve Bank’s last monetary policy committee meeting, keep your repayments unchanged.
There is, however, a caveat: Which money do you use to pay off your debt? Do you use your pension/provident fund money when you leave your employer? Do you liquidate your tax-free savings account and other long-term investments?
The answer is a resounding no!
The problem with “quick fixes” is that you never cultivate good financial habits; it is very easy to find yourself back in a debt hole if the same habits that got you in debt in the first place are not addressed.
To pay off debt, you might have to pause making contributions into your investments until all your consumer debt is paid off. But this requires planning. If you are leaving your employer, do not take your funds in cash. If you do that you will pay a hefty tax bill and, secondly, you will lose out on the compound interest effect your existing funds could earn in the long term.
Only then will you focus on saving and investing for the future.