A question people often ask when they first become interested in investing is whether they should attempt to pay off any existing debt they already have before dipping their toes in the stock market.
The knee-jerk response to this would be something along the lines of ‘of course you should!’. Given the vagaries of the markets, starting from as firm a financial footing as possible is both sensible and prudent.
It’s a little more complicated than that. Let me explain.
Expensive vs cheap debt
A lot depends on whether the debt in question is expensive or cheap.
An example of the former would be credit cards. These days, even the ‘best’ cards have interest charges of around 19% per annum. Having £5,000 on one of these would cost you a whopping £950 in interest a year. Unless you happen to be a skilled or fortunate short-term trader (a strategy we at the Fool suggest avoiding), you’re unlikely to make the same kind of return on the stock market in just twelve months. Even if you do, the odds are stacked against you repeating the feat the following year. There’s only one Warren Buffett, after all!
There is, however, a caveat to this.
Many credit cards give their owners a holiday period in which no interest is charged. Using the above example, having £5,000 on a 0% credit card and paying the debt off in regular installments over a number of years is financially savvy so long as you can remain disciplined. In this scenario, throwing any extra cash at the markets might be more appropriate.
The same logic could be applied to mortgages.
If you’ve taken out a mortgage (or just a personal loan) over the last few years, you’re likely to be paying a low rate of interest. In this situation, the return you get from the stock market could be higher. Bear in mind, however, that interest rates are only likely to rise moving forward and that the option of making overpayments is still worth considering.
Given that a mortgage represents a long-term debt for most people, waiting until the loan is fully paid off could also be detrimental to your wealth since you are restricting your ability to really benefit from your investments compounding over time. As the adage goes, “it’s not timing the market, it’s time in the market” that ultimately leads to riches.
Taking the above into account, it may therefore make sense to drip-feed any remaining cash into the market through a tax-efficient stocks and shares ISA. Arguably the ‘safest’ (and cheapest) way of doing this is to invest in a few index trackers or exchange-traded funds, giving immediate diversification and a dividend stream to reinvest. Those with more appetite for risk could buy shares in large, resilient companies with dependable payouts. Only once they feel comfortable should attention be turned towards some of the market’s smaller constituents.
Bottom line
When it comes to debt, it makes sense to clear any high-interest debt first (and, ideally, have some kind of emergency fund in place). Once sorted, a balance between paying a mortgage/saving for a deposit and putting any spare cash to work in the stock market makes sense.
As always, however, a sober evaluation of your financial goals and risk tolerance is essential before making any big money decisions.
