Debt is something that most of us will deal with in life one way or another. Maybe it is a credit card debt, a car finance loan, student debt, a mortgage, an interest free loan or anything where you have borrowed money and need to pay something back over a period of time; in most cases with interest on top.
Regardless of the type of debt you have, you will want to make sure that you're keeping it under control and in most cases, be completely free from it. After all, a part of reaching financial independence is to become debt free so that there isn't anything eating away at your wealth and possibly becoming a bigger problem over time.
There's nothing worse than losing control over a debt that started as relatively small, but became a massive financial liability due to the high interest rates and payments building up over time. This is especially true if you're trying to build up your wealth over time by investing your money; any gains you might make will eventually just be negated by the interest payments you owe.
Let me show you what happens when you ignore a small debt with high interest over a period of time, and how it kills any progress you might make in the long run from your investments. Here are the example numbers I will use for this article's calculations:
Investment: £1,000 growing at 7% annually
Debt: £250 with 19% interest each year
Notice how the debt is much lower than the investment; this is to highlight how quickly it can get out of control even though it only looks like a small problem at the start. The example percentages are from average examples of a credit card interest rate and the long term growth of a globally diversified investment portfolio.
If you don't pay your debt
Here is what happens in the first couple of years if you don't pay your debt and keep all of your money invested instead:
What you might notice from the table is that in the first couple of years the investment is outpacing the debt; after 1 year the investment gains £70 whereas the debt has "only" grown by £47, so it would appear that everything is alright. And if you look at the last column for the difference in investment value against debt balance (Investment minus Debt) it seems as though the amount is getting larger as the years go by.
So that means your money is better off in the investment rather than paying off the debt right?
Take a closer look at the difference numbers again. Notice how the amount that it increases by each year is getting smaller and smaller, and after 4 years it has only increased by £6 (£810 - £804). Here is what happens in the 5th year:
The difference of £806 after 5 years is the first time where it is less than the previous year. This is a turning point that signifies your debt balance is now growing more each year in comparison to your investment value growth.
There is also a dangerous assumption in this calculation, and that is the consistent return on investment at 7% each year. While this level of return on average isn't unreasonable based on a broad index fund that covers a global market, it is something that cannot be guaranteed in the future simply based on the historical performance.
In contrast to this, interest on your debt is unfortunately a guaranteed (and persistent) figure and will keep hitting you and your wealth no matter what happens. There most likely won't be a year where the interest rate on your debt is suddenly much lower and therefore the debt balance grows less. But if the growth on your investment drops for even a single year then the difference between investment value and debt balance will only grow wider and wider.
This goes to show that without taking undue risk on your investments it is practically impossible to invest your way out of high interest debt. Any sort of investment that might offer a high rate of return will undoubtedly come with even higher risk and volatility. You would essentially be gambling if you were to choose this option in an attempt to outpace your debts.
Here is what happens if we keep going into the future years with the example calculation:
Ever since the turning point in the 5th year, the downward trend for the difference between investment value and debt balance has continued. By the 8th year the difference is less than what you would have started with (£750), you can confirm this by simply looking at the first row in the first table. This means that all of your investment progress has been lost due to your debt eating away at it; you would've been better off just paying off your debt and not investing at all.
And if you look at the next 5 years:
I think by now you get the point, but as you can see in the 14th year all of your investments including the principle amount that you had to start off with would effectively be worthless. You are not only in debt, you are negative £277 overall.
If you look at the investment value and debt balance at this point you can see the stark differences in how both have increased. Your investments will be two and a half times more than what you started with, which sounds really good, but the debt you owe will be over ten times more than the £250 you owed in the first year.
Here’s another scary thing about this scenario, look at how quickly the difference is growing in the 15th year. By going from negative £277 down to negative £638 you would have effectively lost £361 in a single year, that's almost half the amount of the (positive) £750 difference that you had at the very start.
Obviously this example assumes that you somehow didn't make a single payment towards your debt for the whole 15 years, but the intention of this calculation is to drive home the point that dealing with your debts early is much, much easier than dealing with it later.
If you paid your debt straight away
This example wouldn't be complete if there wasn't a calculation to show what would have happened in those 15 years if you had just paid off your debt straight away. It might mean you have a little bit less invested, but let's see what happens in the long run:
I didn't want to drag this out with another three tables so I've gone in increments of 5 years, but that should be enough to get the message across.
At the start you pay off your debt of £250 by using some of the money in your investment. That will mean your investment grows slightly slower each year as the starting amount was less (£750); but all you need to do is look at the difference column (Investment minus Debt) to notice that it only takes 5 years for you to build your investment value back up to over £1,000.
That's a 40.2% return on your initial investment which is nothing to scoff at.
After 15 years you would be £2,707 wealthier than the version of yourself who didn't pay off their debt early. As you would have £2,069 here whereas the other version of you was negative £638.
£2,069 - (-£638) = £2,707
Not bad for a small payment of £250 wouldn't you say?
It doesn't escape me that this is a very generalised example with a bunch of assumptions but nevertheless the lesson and message should still stand. I wanted to take an example and work through the numbers to really highlight the fact that the earlier you pay off your debts the better it is overall for yourself, both in terms of getting to financial independence and also just in terms of your overall happiness.
Debt is something that can really take its toll on people both financially and psychologically, especially if the repayments are dragged out over a very long time; and I get it, sometimes there's no faster way you can deal with it. But as much as it may hurt or cause you a headache, don't ignore it. You have to deal with it eventually and so the sooner you can get yourself back into control the better.
I've dealt with debt myself so I know how hard it can be. In a future article I will go through some more calculations when it comes to tackling debt, and how the numbers can play out over time to help you make a better informed decision on how you might be able to get yourself back out of a hole.
Until that time, I hope this article has been interesting and was able to give you a bit of insight into how debt can quickly grow into a very big problem, even if it starts off as something relatively small.
Update: Just finished an article on how to tackle your debt by gathering the right information and getting a clear understanding of your overall situation. Check it out here.