Should you pay off debt or start investing?

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In an ideal world, most of us would like to save more and reduce debts to put our finances on a firmer footing. The question for many is which of these options should we prioritise?

Do the maths

The first step is to understand what debts you have, and how much interest you are paying. Typically shorter-term credit, such as credit cards and store cards, charge far higher rates of interest than longer-term debts, like mortgages.

Next, look at how these various interest rates compare to the returns you might get by saving or investing this money instead of paying off debt. With savings accounts this calculation is pretty straightforward. The interest rates paid on savings accounts are far less than the rates banks charge for loans and credit cards. According to the data provider Moneyfacts the average APR charged on a credit card is 24.7% while the best-paying easy access bank account, pays just 1.45%.

When it comes to investments, returns are harder to predict. However, industry guidelines suggest that stock market-based investment plans, like an ISA, should return between 3 and 5% a year over the longer-term. It’s important to remember that these are only projections, and returns are not always guaranteed. You will definitely be paying the set interest on a credit card, but you may not get anywhere near this return on an investment. In fact, you could also lose money.

Looking at the simple maths it makes sense to focus on reducing debts first, particularly short-term expensive debt first.

This will not necessarily apply to larger longer-term debts, such as a mortgage or a student loan. For starters, few people will have the money to hand to pay it off in full so structured payments over a longer period can make sense here. Also there can be additional fees if you try to pay these types of longer-term loans sooner than you originally agreed.

Switch and save

Rather than simply paying off debts in full, look at whether it is possible to switch providers to reduce interest charges. You could consolidate multiple debts into one loan. Some credit cards have interest-free offers (often up to a year) giving you the time to reduce the balance without incurring further charges. However this is only for the more disciplined spenders: if you know you may be tempted to use these offers to spend more, concentrate on paying some of the outstanding balance instead.

Getting into the savings habit

For many people this doesn’t have to be a binary either/ or choice. While the maths may point you towards reducing debt, psychologically many people may feel more financially secure with a cushion of savings. These can be short-term ‘emergency’ savings or longer-term investments, such as pensions and ISAs.

Remember it isn’t just the ‘return’ you earn on your money that is important. Even if you are investing relatively small amounts each month, these can build up to more substantial savings over time. Building up your savings can have a positive effect on how you view your finances, and may encourage you to save more, borrow less and budget more effectively.

In this day and age it is hard to avoid debt completely. Many of us need credit to buy a home, run a car, pay for our education and to cover temporary shortfalls — be it holidays, starting a new job, or paying for a new boiler — when monthly outgoings temporarily exceed our income.

Those wanting to take control of their personal finances, need to ensure they are not paying over the odds for this credit, and then look to reduce these debts at a sensible rate, while continuing to save and invest for the longer-term.

As you get older you want to change the make-up of your personal finances from ‘few savings and large debts’ to ‘small debts and big savings’. This is unlikely to happen overnight, but you can start working towards it from today.