Step one - demolish debt before investing

By Mark Fryer

Pssst ... have we got a deal for you - an investment that pays over 11 per cent, absolutely guaranteed, for as many years as you need it. And it's easy too.

The investment in question is repaying debt - clearing your mortgage, your credit card, and any other loans as fast as possible.

It may not be the most exciting financial strategy around, but for most of us there is no point in embarking on an elaborate investment plan until we clear the ground by getting rid of debt first.

The reasoning is straightforward. Every dollar you pay off a loan saves you money by reducing the interest payments. If you are paying 7.5 per cent on your mortgage, for example, that saving is about the same as the amount you would earn on an investment that paid 7.5 per cent.

But if that investment produces income, it will be taxed. If you're on the 33 per cent tax bracket, you'll need to earn just over 11 per cent in order to end up with 7.5 after tax.

On the 19.5 per cent tax bracket you'd need to earn about 9.3 before tax to be better off than you would be by repaying the mortgage.

You may well be able to find investments that produce those sort of returns, but that's not quite the issue. The question is, can you find something that produces them with no risk, no fluctuations, and very little work on your part? If you have debts with higher interest rates, such as credit cards, early repayment makes even more sense.

This is of course the conventional wisdom, as espoused by the Retirement Commissioner, who says repaying debt before starting to invest is the best step for most people. He does make one exception though - if your employer offers a subsidised superannuation scheme, the returns there may be so good that they beat debt repayment.

A straightforward debt-reduction strategy may also make less sense if you are actively borrowing to invest (typically in property) - and you know what you are doing.

For most of us though, getting rid of debt first will be the best approach, and it's easy enough to engineer. First, try consolidating your debts onto the lowest rate you can. If you have a credit card debt and a mortgage, for example, see if you can increase the mortgage to pay off the card.

From then on it can be as simple as just paying as much as you possibly can every month.

That may not always be possible; fixed-rate mortgages typically don't allow you to make extra payments without paying a penalty, although you can always put the money aside for when the fixed rate period expires.

More flexible floating rate loans make extra repayments easier, and if you have at least part of your mortgage on a revolving credit loan - and have the discipline to handle it - debt reduction can be more effective still. The trick with such loans is to have your income paid directly into the loan account, and delay paying bills as long as possible.

If you're worried about putting everything into the mortgage and having nothing in the bank for a rainy day, the revolving credit arrangement can cover that - you simply withdraw some money and go deeper into debt if an emergency arises.

That easy access to credit may be just too tempting, in which case you can provide for any emergencies by having a loan with a "redraw" arrangement that lets you take back out some of the money you have previously paid in. Whatever arrangement you use, the aim is to avoid having money in the bank, earning very little, while at the same time you are paying much higher rates on your debts.

* For more on debt-reduction strategies, see Martin Hawes' 5 Ways to Save More Money on Your Mortgage, due in bookshops next month.