If you have debt, you should pay it off as soon as possible, shouldn’t you? Actually, the answer depends on the debt…
Debt is a growing worry, with British households now owing a mind-boggling £1.67 trillion in collective debt, which works out as an average £59,982 per household, including mortgages. Here's how to go about correcting it.
Pay down short-term debt
If you have taken out short-term credit, such as a credit card, store card or in the worst instance, a payday loan, then yes, you should use any spare money to pay that debt down. Credit cards charge APRs starting from 20%, which rises to 30% on many store cards, while with payday loans, the sky's the limit.
Start by aiming to clear your most expensive debt first, then when that is cleared, the next most expensive, and so on, a process known as “snowballing". Remember to make minimum payments on your other debts, to avoid penalties.
The sums add up
It makes total sense to pay off expensive short-term credit rather than save money in the bank or invest in the stock market, because no investment can guarantee to generate 20% or 30% a year or more.
Once your high-cost debts are sorted, build enough savings on instant access to cover your living expenses for six months, in case of emergencies such as redundancy or serious illness.
The decision to pay down long-term mortgage debt is more complicated. Mortgages charge much lower interest rates than credit cards, currently, you can find deals charging as little as 2 or 3 per cent a year.
That is incredibly low by historical standards, and greatly reduces the need to pay them down off quickly.
Strike the right balance
There are still benefits to overpaying your mortgage, as this will clear the debt faster, and cut the total interest you pay. However, you also need to invest for retirement, which is another tough task, and the earlier you start, the better.
Over the long run, stock market indices such as the FTSE 100 deliver an annual average total return of around 7% a year, from a combination of capital growth and rising share prices, and dividend income. This is more than most mortgages charge, so there are strong arguments for prioritising investing over paying down the mortgage.
Balance it out
The key is to strike the right balance, by keeping your mortgage on track, while making sure you invest enough for retirement.
You can invest either through a pension, which gives you tax relief on your contributions, or a Stocks and Shares ISA, where all your returns are free of income tax and capital gains tax.
Of course, by far the best way to manage debt is to avoid borrowing too much money in the first place.
Read more: How to be smart when saving for retirement
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