There are a range of factors to consider when weighing up the choice of either paying off debt or investing.
Q: I’m currently paying off my $10,000 student loan, which is scheduled to be fully repaid late next year. I’m also contributing $50 a fortnight to a low-cost index fund to support my retirement savings.
Would it be more beneficial to redirect that $50 toward paying off the student loan faster and freeing up more of my salary each fortnight long-term, or is it wiser in the long run to continue investing and take advantage of compound growth?
A: Good on you for saving that fortnightly $50. It will really add up over time.
I assume you are also in KiwiSaver and getting the maximum from your employer and the Government. If not, do that first – because the employer and Government contributions really boost your savings.
On weighing up the index fund versus paying extra off your student loan, compare the index fund return, which is probably at least 5% after fees and tax on average, with the interest you pay on your loan, which is zero (assuming you live in New Zealand).
You will do better going with whichever is higher – in this case clearly the index fund.
That might change if you moved overseas and were charged interest on your student loan.
Q: I have been paying into a private investment fund for the last 25 years. It’s now worth about $450,000, the same as I owe on my mortgage. With my private scheme, I can draw the whole lot down at 55. I’m now 52. When I get to 55, should I draw down my fund to pay the mortgage and avoid interest? Or should I hold?
A: This is a variation on the above Q&A. In both situations, compare the return on an investment with the interest you pay on a loan.
But the answer is less clear-cut for you. While you’ll know your future mortgage interest – at least for a while – you won’t know how well your fund will perform after fees and tax. It might or might not exceed the mortgage interest.
In these situations, paying down the mortgage probably wins – partly because it’s good psychologically to get rid of debt. Or you could do 50-50.
Today’s excerpt from my book Rich Enough? is also about repaying debt versus investing – but it’s entirely different debt from a student loan or mortgage.
Q: We are in our mid-60s and recently, our medical insurance premiums have been increasing dramatically – an average of 18% over the last four years.
Some of our friends in their 60s and 70s don’t have medical insurance because they either can’t afford it or they “self-insure” and rely on the public health system.
Given the waiting lists in the public system, we didn’t like that option. We considered self-insuring by putting away our monthly premiums in a separate account, but it would be many years before it built up substantially.
If we had a major medical event (knee/hip replacement, cancer, etc), we wouldn’t have sufficient funds to cover costs privately.
We have decided to put a $4000 annual excess on our health insurance policies, which has halved our premium costs. We will put the premium saving in a separate account to cover the excess, but we still have cover for any major medical event. Is there a better way to manage this?
A: I think you’ve done it perfectly.
Older people often complain about how fast health insurance premiums increase. But you don’t have to look far to understand why. And if an insurance company subsidised the oldies by charging younger people more, the young ones would probably just not have insurance.
Anyway, your solution should work well. You know that you’ll pay up to $4000 a year for health expenses, but no more than that. And, as you say, your saved premiums will help with the $4000.
You can also reduce premiums by changing what’s covered – for example, excluding GP visits.
Another approach, discussed in last week’s column, can work if you have a mortgage-free home. If you suddenly face big health costs, get a reverse mortgage or home reversion.
This is one of three excerpts from Mary’s revised and updated No 1-bestselling book Rich Enough? A laid-back guide for every Kiwi, published by HarperCollins Aotearoa New Zealand.
Psst! Have I got an investment for you! No, we need more exclamation marks. Have I got an investment for you!!!! It’s easy!!! And it pays you 20% a year!! At no risk!!
I hope you’re looking at me sideways. “What’s Mary up to? This is definitely too good to be true.” That’s exactly how I would want you to respond to any “low-risk” investment offering more than very low interest.
But this is different.
Oops! I hope you’re looking at me even more askance. The “this time it’s different” line should make all the warning lights flash.
So what am I on about? Paying off high-interest debt.
I hate seeing people with expensive debt – often run up on credit cards, Buy Now, Pay Later or through a finance company, to buy a car or computer or something. (To keep things simple, we’ll call it all credit-card debt. The same principles apply to other high-interest debt or high-fee borrowing.)
Most credit cards are run by banks – and they must love people with big card debt. Banks take in people’s money – in savings accounts and term deposits – and they pay pretty low interest on it. And they lend money out – for mortgages, business loans and credit-card purchases – and charge higher interest on it, especially on cards.
To some extent, that’s fair enough. They’ve got to cover the costs of running the business, and losses on loans that aren’t paid back. They’ve also got to give profits to their owners, the shareholders. But those profits are awfully big these days.
In light of that, I can’t see how banks can justify charging around 20% on credit card debt. But they often do.
And people pay. According to credit-scoring company CreditSimple, one in three New Zealanders don’t pay off their credit card in full each month, which means they pay hugely high interest on the balance. Presumably, most make the minimum required payment, which is a con. If that’s all you pay, your debt is likely to grow rather than shrink – even if you make no more purchases.
And it gets worse. More than one in 10 said in a survey that they’re comfortable with credit card debt of up to $10,000. Horrors!
Let’s start, right now, on a campaign to deprive banks of the profits they make on credit cards. How? Don’t pay their high interest rates by not having the debt in the first place.
Too late for you? Well let’s get rid of it.
You’ll be in good company. In a New Zealand survey conducted a couple of years ago, nearly three-quarters of the people said they are concentrating on reducing and minimising their debt.
If you have a 20% credit card debt and don’t pay it off, the compounding can be truly frightening.
Let’s say you owe $1000 and make no payments. After a year, you’ll owe $1200. The next year it will be $1440, then $1728, then $2074. The debt has more than doubled in just four years.
The year after that it’s $2,488, then $2,986, $3,583, $4,300, $5,160. After nine years, your $1000 debt is more than five times as big. That’s horrible.
If you’ve got credit card or similar debt that you don’t expect to pay off on the next bill, in an odd sort of way, you’re lucky! You can take advantage of that 20% “investment” – or thereabouts – touted at the start of this step.
How does that work? Let’s start by considering how we measure financial wealth. We could look at the things somebody owns – properties, cars, shares, whatever. But what if a big spender has borrowed to the hilt to buy those items?
Their debts might even be bigger than the value of their assets. That might not matter for a while. But what say they loses their job, or their business founders in a downturn and they need to sell some assets to buy the groceries and clothe the kids?
Because the economy has slumped, others are in a similar plight, so there are lots of properties, cars and shares on the market, going cheap.
Desperate to sell, our hero accepts low prices. In an extreme case, they might find themselves with no assets to speak of but still owing money to the bank. Wealthy that ain’t!
A true measure of our wealth is the value of our assets minus our debts.
In a fascinating book called The Millionaire Next Door, Thomas J. Stanley and William D. Danko draw on their research on American millionaires. They found that most professional people looked wealthy, judging by their homes, cars, clothes and lifestyles. But many were like our big spender. They had borrowed heavily to live that way. Subtract their debt from their assets and there wasn’t much wealth left.
Stanley and Danko found that many of the actual millionaires were the folk next door, who had lived in the same nice but ordinary house for decades, often ran small businesses, and kept their debt low.
So what’s all this got to do with you? To keep it simple, we’ll say you have:
As we said above, your wealth – sometimes called your net worth – is your assets minus your debts. So your net worth is:
$30,000 – $10,000 = $20,000
One day, you hear that your sweet old Auntie Mabel – bless her – has died and left you $5,500. What do you do with it?
Firstly, you blow $500 on a party or a weekend away. Life is for living, and not every penny needs to be spent sensibly! But should you put the remaining $5,000 into term deposits or pay down debt?
If you put it in term deposits, your assets will grow to $35,000. So your assets minus debts look like this:
$35,000 − $10,000 = $25,000
If you use it to reduce your credit card debt, that debt will fall to $5,000. So we have:
$30,000 − $5,000 = $25,000
Key message: reducing your debt has the same effect on your wealth as adding to your savings.
So which is better? Here’s where it gets interesting, or should we say interest-ing? Look at:
The choice is obvious. It’s far better to reduce 20% debt than add to 3% term deposits.
In fact, reducing 20% debt boosts your wealth as much as adding an investment that pays you 20%. No sound investment can promise 20% without big risk, but reducing debt is risk-free. It’s a no-brainer “investment” for anyone with high-interest debt.
A couple of quick points.
The first point is that when I said you’re lucky for having this debt, I didn’t really mean it! You’re actually unlucky, to put it charitably. Many would say you’re stupid, but I’m not that mean. Whatever we call you, it’s not clever to have high-interest debt. You’ll often end up paying twice as much – or more – for something because of all the interest you pay.
You’re lucky only in the sense that you’ve done something so bad that changing it will be so good!
The second point is for anyone wondering how mortgages fit into this. A mortgage is certainly debt. But it’s a far cry from credit card debt for a couple of reasons: the interest rate is much lower and you’re buying an asset that will almost always grow in value over the years.
Still, it’s a good idea to get rid of a mortgage quickly, too.
* Mary Holm, ONZM, is a freelance journalist, a seminar presenter and a bestselling author on personal finance. She is a director of Financial Services Complaints Ltd (FSCL) and a former director of the Financial Markets Authority. Her opinions do not reflect the position of any organisation in which she holds office. Mary’s advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to mary@maryholm.com. Letters should not exceed 200 words. We won’t publish your name. Please provide a (preferably daytime) phone number. Unfortunately, Mary cannot answer all questions, correspond directly with readers, or give financial advice.
Commercial property yields in NZ range from 5% to 8.38%, higher than residential.