Debt is something that you should consider tackling before you begin to invest in earnest.
It is a very important money management step and its definitely worth considering.
The obvious reason for doing this is that with debt, your account or balance is in a negative state and since you have to pay back that loan eventually, you may as well start paying it back now.
Also, if you have debt against your name, then you will be restricted from conducting some financial transactions or at the least you may be penalised by the terms associated with those transactions. For example, if you already carry some debt, you may find it difficult to obtain a credit card or you could be refused a mortgage or if you just want another loan, then the terms may be very unfavourable to you.
Another reason why you should clear your debts is because it is costing you – most loans require you to pay interest. For every pound or dollar of debt you have left outstanding, you have to pay interest until that debt is cleared.
So paying off your debt sooner rather than later will actually save you money in the long run.
If you are unable to clear your debts then do not consider investing just yet. This is because the returns that you may receive from investing are almost certainly going to be less than the interest you are paying on your loans. So you will definitely become worse off !
Also, since investing carries a degree of risk (the value of your investments will go up and down over time), then you may end up with less than you started with at any random point in time. The last thing you need when in debt is to be forced to cash in your investments at a loss exactly at this time.
So, before you begin to invest, clear your debts. Whatever your debt is, make a plan to pay it back and then actually start paying it back. Don’t wait.
Being debt-free puts you into a very strong financial position and is the first step towards financial freedom.
Now, let’s get more specific…
If you have just one loan then you can just pay it off steadily. But what if you have more than one loan – what should you do ?
You may not have the means to chip away at all of your loans at the same time with the same monthly repayment. So you need to determine a priority or an order in which to clear your debts. Here is one way you can do this:
If you take a look at your loan agreement documents, you will see that you are required to pay interest for as long as you hold the loan until every dollar or pound has been paid back. What you need to do in order to determine which loan to payback first is list them in order of interest rate.
In simple terms the loan with the highest rate will cost you more in terms of paying interest.
For example, imagine if you had 3 loans (debt) as follows:
* Credit card debt with an interest rate of 19% per year.
* Car loan with an interest rate of 11% per year.
* Home improvement loan with an interest rate of 5% per year.
If the terms and conditions of these loans are the same and there are no additional costs, then this is how much interest you will pay each year for every $1000 left outstanding..
* Credit card debt at 19% = $190 interest cost per year for every $1000.
* Car loan at 11% = $110 interest cost per year for every $1000.
* Home improvement at 5% = $50 interest cost per year for every $1000.
The credit card debt is costing you more in terms of interest than the car loan. Similarly, the car loan is costing you more interest than the home improvement loan. Therefore, to save on future interest costs in the most efficient way, you would consider paying back the credit card debt with the high interest rate before the other two loans (which have lower interest rates).
The quicker you can pay back high interest loans, the quicker you will clear your debts and the sooner you will be in a position to start investing.
If you would like to understand more about finances and investing, then let’s talk >>>
(image attribution: 0299 Bulldozer by Mark Morgan from flickr)