Editor’s note: This article was first published in June 2013, in the middle of the economic crisis in Spain. The interest rates it quotes, such as 15% APR personal loans, 13-21%, and over 40% annualized on some credit cards, reflect that moment and market.
Few people stop to think about the heavy impact debt can have on their total wealth and their future.
Sometimes we look for investments that can deliver an eye-catching return so we can pay off part of what we owe. So what is the most profitable investment? Without a doubt, investing in paying off your own debt.
We tend not to worry much about our debts while we earn enough to pay them, even if we live paycheck to paycheck. We may even forget about them, and only notice they’re there when, at some point, we struggle to meet the payments.
(Read: 5 signs you’re living beyond your means.)
We have all kinds of debt: personal loans, mortgages, credit cards (the most toxic debt there is), student loans (where they exist), and so on.
The good thing about investing in paying off debt is that you can earn a return of 15% or 23% on your money in a completely safe way, without taking on any risk. How can that be? It’s simple, and it’s something many people don’t see this way.
By paying off your debts, you lock in a return equal to the interest rate you pay on them
Put simply:
If we owe €10,000 on a personal loan at 15% APR and we manage to save €10,000, then when we ask ourselves “where should I invest my €10,000?”, the answer is clear: by paying off the €10,000 debt you’ve earned a 15% return on your money, because, in the end, you were going to pay that 15% whatever return you got from any other investment. That way, you’ve earned that return with zero risk. And on top of that, you’re now free of that debt.
With some credit cards, where interest is calculated monthly on the total outstanding balance, if we “annualize” the interest we pay on the card we could be talking about more than 40% a year. That completely destroys your financial future, even if you don’t realize it now.
See also: 5 things rich people do with their money that you should be doing too
Why don’t most people get rid of their debts?
Some will say it’s because, with the crisis, they can’t. And that’s true: it may not be possible right now. But it’s a question of mindset, because when we were able to pay off our debts, what we did was take on more. Many people, if they could clear their debts six months from now, probably still wouldn’t.
The biggest problem we see when it comes to fighting debt is the time factor. When someone is offered a financial plan based on their earnings or savings, they’re given a timeline that can be very long, and that discourages them.
Charlie Munger said in his 5 steps to getting rich that it’s impossible to grow financially while paying interest of 13% or 21%.
Some time ago we told the story of Stephanie, a young woman who fell into the debt trap and, thanks to a financial plan, managed to pay off $90,000 of debt in three years. Had she not done it, those three years would have gone by anyway and she would be even deeper in debt.
That’s why we always insist that before looking for investments, especially in the stock market, where a long-term approach is recommended, we should try to be debt-free. All the more so if we have debts charging more than 10% interest: in those cases, by attacking the debt we’re already getting a good return on our money without having to take any risk.
See also: 11 ways to save more money on small things that add up over the year
To some people, what we explain in this article is obvious. But I know of people who have invested €10,000 in 12-month government debt (Spanish Treasury bills) while still owing €5,500 on a personal loan and €1,500 on a credit card, which shows it isn’t so obvious after all. It’s a question of mindset: in my view, from a financial-mindset perspective, that government debt investment is making you lose money because you didn’t pay off the debt first.
