Here’s a question I saw online in a financial discussion forum:
“I would like to ask some advice from you. I have recently came into a small windfall of money to the sum of £3K and wondered what best to do with it. Not a lot I know, but for my salary its quite a bit.
Initially my thoughts were to either:
– Invest into a stockmarket tracker fund?; or
– Start saving towards a deposit for a flat?
…but then I wondered whether I should use it to pay off my credit card debt or my student debt?”
This is a bit like someone asking what type of garden furniture they should be buying when their roof is on fire.
Often in personal finance there is no right or wrong answer, its down to individual preferences. But here there is a correct answer and it goes something like this:
Why are you talking about investing in the stockmarket or buying a house?
First things first…you have CREDIT CARD DEBT and that is an EMERGENCY. You need to pay that off, right now!
This was a mild case. The windfall was enough to clear the credit card debt, problem solved. But the fact that someone was even asking the question made me realise how much
financial illiteracy confusion there is out there.
I’m sure you realise that debt is a trap, but perhaps you could forward this article to someone (especially a young person) that needs to know this?
First things first
Let’s say you’ve locked down your spending and have some money to throw at your debts / savings / investments. Where should it go?
Well, first things first…there is a hierarchy of priorities:
- First you pay off payday loans and bank overdrafts (typical interest rate ~40%).
- Next you pay off credit cards (typical interest rate 20-30%).
- Next you build up an emergency fund of 3-6m expenses in cash in an instant access bank account.
- Next, have you cleared all expensive consumer debt? (excluding a mortgage but including personal loans, hire purchase, car lease payments etc)
- Now (and only now) you can invest in the stockmarket.
[Note: I have excluded UK student debt which is more like a graduate tax that depends on earnings and so depends on individual circumstances.]
Getting out of debt is an emergency
This is an emergency. You must get out of all expensive debt as soon as possible. Credit cards and overdrafts are the most common ways that people dip into debt at the end of the month.
The annual interest rate on most UK overdrafts is about 40% per year. Based on the interest alone, the amount you owe will more than double within 2 years at 40% interest. The interest rate on credit cards is something like 25%. This means that the amount that you owe them will more than double within 3 years.
Who will tell it like it is?
The problem with that is that people in debt often don’t have good role models around them.We all have a money blueprint and for most of us the biggest influence on this would have been our parents. What if we never had people around us that warned us to stay away from debt?
It would be easy to avoid this subject. Most people (including me) don’t want to be seen telling people who are struggling with debt what to do. But that leaves a gap filled by the advertisers, marketers and credit card companies.
No blame, no shame
I actually think the older generations have let down young people. We used to teach young people to prepare for a life with struggles, a life that would test them in all sorts of ways. Now our we sell young people instant gratification via stuff they don’t need on credit cards then pretend its fine because everyone is a rational, well-informed economic agent.
Well, that doesn’t work because you are a habit machine. Once you are in the habit of being in debt and spending above your means, you need a period of cold turkey (see Monk Mode below) to break those habits.
If you are young and in debt, I’m not saying it’s your fault but it is your responsibility. I’m not interested in blame or why anyone came to be in debt in the first place. This is not a moral judgement and I’m not interested in the past or in reasons, rationalisations or excuses. We are where we are and all that matters is what we do from this point onwards.
The hardest thing is often acknowledging your reality. The best way to do this is to create a spreadsheet that records how much you owe, to whom and what interest rate you are paying on the debt.
The interest rate is the speed at which your compounding machine is running backwards. The higher the interest rate, the more rapidly your net worth is shrinking. The APR stands for the annualised percentage rate, the effective interest rate you are paying. Banks and credit card companies have to show this to allow you to compare different debts on an apples to apples basis.
You can then rank the debts by interest rate (highest first) to show you where your repayment priorities should be.
If you need someone to talk to, there are sources of free and independent debt advice out there:
- The Citizens Advice Bureau
- National Debtline
These guys can give you free and impartial advice about the law and your rights. Avoid private sector debt consolidation / debt advisory services. For all I know, some may be offering a valuable service. But will people in debt problems really be able to tell the good from the bad? Probably not.
Debt makes you fragile
The problem with student loans is that they have normalised debt for an entire generation of young people. Debt is OK where it funds a productive asset (a house or medical training to become a doctor). But if you start your adult life running up debt for a degree that doesn’t get you a job, for buying a car or for buying “stuff”…well that’s like starting a football match 3 -0 down.
The problem is that debt makes you fragile. If you are living paycheck to paycheck and juggling credit card balances, then one day something will happen that could bring the house of cards down. Bad things happen. Exhibit A: CV-19. This is why I don’t recommend having balances on 0% deals that you shuffle every 6 months. This is like spinning plates; one day a plate will drop. Clear all credit card balances.
If this sounds extreme,then consider this. Everything in moderation…including moderation. When you are you are digging your way out of a hole, the sooner its done the better.
A lot of people think that debt is their problem. But debt is just a symptom of an underlying problem (either spending too much or earning too little). Monk Mode is a way of breaking the pattern, addressing the underlying problem and creating new habits.
Being debt-free gives you most of the benefits of financial independence
For me, the main value of the financial independence movement is what it offers everyone. I’m talking about the realisation that debt is a trap and keeping up with The Joneses is a mug’s game.
Everyone can use the tools, techniques and mindset of FI to improve their own situation and – most important of all – get out of debt.
Not all debt is bad of course. A cheap mortgage currently costs less than the 2019 inflation rate of 1.8%. This is a perfectly sensible way to finance the purchase of a flat / house / apartment and build capital as you pay down the debt. If you use leverage for a smart investment (e.g. buying low, fixing up an old flat or house and then selling high) you can make out like a bandit.
If you have paid off all your non-mortgage debt, have >40% equity value in your property, are on a cheap mortgage rate, have an emergency fund of 6m cash and are working flexibly, then you already have most of the benefits of full financial independence.
If you have cleared your mortgage as well, then I conservatively estimate that you already have ~80% of the benefits of full financial independence.
Debt is the barbed wire fence around The Prison Camp. And being debt free is like clearing the fence. It’s a beautiful feeling.