Tackling debt head on certainly takes time and effort, but it may be one of the best investment decisions you can make
I recently read a comment by the U.S. Federal Reserve, which observed that paying off personal debt …
“has a riskless return that averages around 14% and which no other asset class can match…”
A comparison was then drawn between that 14% and the long-term average annualised returns for the S&P 500 Index, which between 1973 and 2016, averaged 11.69% per year.
A more current figure shows that the S&P 500 Index averaged 7.42% over the last 20 years to the end of September 2018 (in US$). Either way, I thought this was a really good angle to illustrate the ‘return potential’ to paying off debt.
Rising personal debt levels are a trend among many parts of the world, helped in recent years by the unusually low-interest-rate environment in many economies.
Here in the United Kingdom, general consumer credit has been trending higher for the last several years, growing at around 9% per year:
A big driver of consumer debt is credit cards, the vast majority of which charge extortionate rates of interest for the privilege of using plastic. The Money Charity suggests that the average APR for credit card debt in the UK is 18.35% – and that’s just the average!
I have seen other statistics which suggest the figure is nearer 23%. Either way, at these levels it’s a major, major problem!
To draw a similar comparison to above, compare that 18-23% to the long-term average annualised returns of the U.K. stock market, as measured by the FTSE All-Share Index. Over a 20-year period, to the end of September 2018 (total return, with dividends reinvested), U.K. stocks have an average annualised return of 6.3%.
While you can’t buy the index, you might get similar returns via an appropriate tracker fund or ETF, but even then there would be some fees to account for that would drag those returns a little lower.
Hopefully, this example will do a lot to convince you that paying off debt has some pretty compelling maths behind it. The problem is that, while most people will intuitively know it makes sense, we are generally quite lazy creatures by default and the tendency is there to just accept paying the least we are contractually obliged too – i.e. taking a ‘passive approach’. But this really can cost you down the line….
let’s say you pay off a £2,000 credit card balance that was charging you a moderate 15% interest rate – some way cheaper than those averages we spoke off. You now pay £300 less on your credit card bills over the coming year – and every year thereafter. Not only that, the money you were spending to service that loan could now be put to work into investments that work for you – hopefully compounding at a respectable 7-8% per year in a low cost, diversified equity product.
Prioritizing paying off your debt, particularly unsecured debt such as credit cards is usually the smartest move you can make. Why? because it’s highly unlikely that your savings or investments can return a higher rate of return than your average debt interest.
Even in an exceptional year for market returns, such as when the FTSE All-Share returned 30.1% in 2009, paying off debt wins over the long-term. This is because the majority of people will actually get a higher ‘riskless return’. Remember, just as the FTSE All-Share Index, (or any other for that matter) can deliver knockout years, it can also suffer huge drawdowns such as the -29.9% fall in 2008 and the credit crunch.
In addition to the riskless return paying off debt provides, there are other benefits too. Unlike most investment returns, the money you pocket from paying off credit cards or other debts is 100% yours, there is no tax to pay or fees to be charged.
The extra money you’ll eventually save compared to paying off debt improves significantly your cash flow. You can take that money and invest it 🙂
But perhaps the most valuable return you’ll make from clearing debts early is the peace of mind, reduced anxiety and stress and greater confidence in yourself and your financial future.
In a future post, I’ll take a closer look at two of the most popular debt repayment methods – the Debt Snowball and the Debt Avalanche and consider the pros and cons of both using some real numbers.
Until the next time,