(interest – 5 minute read)
In this era of rising interest rates, financial plans change. As they should. Some of us may be looking at ways to maximise their return over the next few financially challenging years. This article is here to tell you that, paying off your debts are the most secure investment you could possibly make.
Target interest bearing debt
Let’s start with the basics: Interest is calculated as a percentage of your remaining debt balance. This is true across most types of debt (credit card, overdraft, mortgages, etc.). Hence, the less debt you have the less interest you pay.
Because of this it’s wise to target interest bearing debt as soon as you financially can. If you have credit card debt, this should be the first one to go (because it has the highest rate of interest). Then you work your way down to paying off debts with lower interest rates.
What about interest free debt?
If you have interest free debt (like a student loan) leave that at the bottom of your priority list. There is no gain to be made from paying interest free debt early. Make only the minimum amount of repayments to interest free debt so that you don’t get penalised.
Interest saved is return gained
Since interest is calculated based on your debt balance, any principal amount of debt you pay off saves you that much in terms of interest. For example:
Stacy has an outstanding credit card debt of $10,000. She currently pays interest of 19% on the balance of her credit card debt. Every dollar that she pays against the $10,000 balance is essentially 19% worth of interest saved on her debt. That’s 19% that she would have otherwise incurred as interest on her debt balance. That’s as good as a 19% return on investment.
In other words, in terms of the interest savings, any payments made towards your debt basically guarantees you a return at the debt’s interest rate.
You know exactly how much you will be getting
Paying off debt offers the one thing that other types of investments don’t: predictability. You will always know how much return you will be getting (saving) based on your debt’s interest rate. You’re locked into a contract to pay X% of interest. This amount isn’t going to change over the duration of that contract. There’s literally no risk of losing money (as with other investments) when paying off your debt.
Should you be paying your mortgage early?
Over the past decade or so, mortgage rates have been historically low. However, that is changing as central banks around the world hike up the interest rates in their respective countries. This has an effect on mortgage rates.
Across the board, we’re looking at mortgage rates of 6 to 7 percent (floating and fixed) from most major NZ banks. This is a far cry from the 4 to 5 percent rates of 2021 and is only set to grow higher in the next few months.
Looking at the mortgage as an investment, this means that you are guaranteed a return of about 7% on any amount that you can pay early. This amount will only increase in the future, so in terms of future savings, you could be looking at a return of 8 to 9% on mortgage payments.
Of course you need to take into consideration early payment clauses and other matters. However, if you have the extra cash to invest, you should consider using it to make payments against your mortgage.
A guaranteed 9% return on your investment.
Are there other investments out there that can guarantee a 9% return with virtually no downside? Not as far as I know. I mean, if you do know, please tell me, so I can write about it in a future article.
I’ve paid off my mortgage, what do I do?
Congratulations! You’re well on your way to financial independence and early retirement! If you have other interest bearing debt still unpaid, pay those first. Otherwise, here are some investments that you could look at:
- Fixed term deposits (interest rates are rising, so term deposits have more attractive interest returns as well)
- Undervalued shares in the share market (industry giants like Facebook, Microsoft and Amazon have recently had their market cap wiped in late 2022 – now’s a great time to snap up these shares at a cheap(er) price!)
- Peer to peer lending. As with fixed term deposits, investing in term investments with peer to peer lending platforms have increased returns as a result of the higher interest rates.
- Index funds are usually a good idea to park your extra funds regardless of economic conditions.
- Or you could ‘invest’ it on an overseas trip, I mean, you’ve paid off your mortgage – you deserve to celebrate!
If you’re looking at investing in rentals in NZ, read this first.
What if I don’t have a mortgage?
If you plan to own a house in the next few years or so, start by looking at secure medium-term investments in which you can plonk your savings into. With interest rates on the rise, term deposits and peer to peer investments are offering better returns with less risk exposure. They are worth checking out!
If home ownership isn’t part of your life plan, have a think about what is important to you and save up towards that instead.
The more debt you pay off, the less interest you pay
It’s that simple really. There aren’t many ‘sure things’ in the world of financial investments but paying off your interest bearing debt is one of the ‘surest’ ways to save on your interest expenses, which then translate into guaranteed returns for you.