Settle Debts Before Investing?

Settle Debts Before Investing?

Jul 31, 2013
Erase/pay off your debts then start investing for a brighter future.

Question: Hi Rose. I enjoy reading your FQ and parenting articles. I also want to start investing now but I think I have to settle my debts first. What do you think? – J.N. via email

Answer: Hi J.N. Yes I agree with you. If you have been carrying debts, which cost you money, the first step is to pay them off. Think of it this way, if you’re able to pay off your credit card debts that charge 3.5% per month, you just “earned” yourself an annual return of 42%! Where can you find an investment return like that?

Sometimes people are also afraid to touch their Emergency Fund to pay off their credit card debts because they want the security of having ready cash for emergency. However, please remember that while your credit card charges you 42% p.a. your Emergency Fund, even if kept in money market placements, only gives you around 2-3% p.a. So pay those loans, then start building your Emergency Fund again. If you have an existing home mortgage with a decent interest rate of 5 to 5.5% p.a., then I think you don’t have to wait to fully pay that before you can start investing. Just make sure that you pay your mortgage on time so you don’t incur penalties and other charges.

I am preparing for a half-day workshop this week for the employees of a government agency. The Human Resources Director asked me to tackle the issue on debt management because she knows that a lot of their employees have debt problems.

She shared with me that their salaries are still given in cash instead of direct credit to employee ATM accounts. When I suggested that they shift to direct credit system in order to nudge their employees to save, she said, “We’re concerned that they might pawn their ATM cards!” I was surprised to hear this and learn that this has become a common practice among people who are living from paycheck to paycheck.

The Origin of Debt:

To know more about debt, I did some research on the origin of debt. I found this book entitled Debt: The First 5,000 Years by anthropologist David Graeber. His interesting theory is that debt originated as early as 3500 B.C., long before the advent of coinage or money in 600 B.C., refuting the traditional explanation for the origins of monetary economies from primitive bartering system as laid out by Adam Smith, the father of modern economics.

I’m not yet done reading the book but it promises to be an interesting read as it talks about how throughout our history indebtedness has led to unrest, insurrections and revolts. The morality of debt is also discussed – how people mired in debt would resort to using their children as payment; how the IMF and the big banks convinced the Third World dictators and politicians to take out loans (while pocketing some in their Swiss accounts) whose interest rates later on skyrocketed leading to the Third World Debt Crisis in the 80s; how the sub-prime lending era crafted mortgages that makes default inevitable, taking bets on these defaults and selling them to institutional investors, turning over the responsibility of paying off debts to giant insurance conglomerates and eventually being bailed out by taxpayers.

What we can gather from this data so far is that debt is really something to be careful with, both on a personal and national/international basis. Inasmuch as it can help us enjoy big-ticket items like buying a house or expanding our business, growing our country without having to put up 100% of cash required, mismanagement can also make life miserable. I’m glad that you intend to pay off your debts now.

Ways to pay off your debts:

The most cost-efficient way to retire your debts is to pay off those which carry high financing cost. And since front-end fees would have been paid by now, these are the loans that carry the highest interest rates. Always make sure you compare the rates on a per annum (p.a.) basis.

However, since handling money is not all about math but has a lot to do about emotions, there are a lot of proponents of the so-called Debt Snowball Method. This method, popularized by Dave Ramsey, advises you to pay off the loan with the smallest outstanding balance first, on to the bigger ones until you pay off all loans. The primary advantage of this method is the psychological contentment that you will feel as you tick off debts from your list. So the smaller the debt, the easier and sooner you can pay it off. You’ll feel the progress more in doing this and give you optimism and drive to pursue until all debts are paid off.

Check which one works for you. As I’ve discussed in previous articles, humans are not always rational and we should work out systems for ourselves such that we move towards our goals more successfully.

May I also remind you not to incur new debts? Review and reflect on how you got into indebtedness so you know what to avoid. Remember debt is bondage. The sooner you get out of it, the closer you move towards your financial freedom. Continue to read up on investing. The more you know about it, the more excited you will be to start the adventure, the more motivated you’ll be to pay off your debts.

Quotes on Debt:

Let me end with some quotes on debts that may be good for you to ponder upon.

“Wars in old times were made to get slaves. The modern implement of imposing slavery is debt.” – Ezra Pound

“If you have debt I’m willing to bet that general clutter is a problem for you too.” – Suze Orman

“In the long run we shall have to pay our debts at a time that may be very inconvenient for our survival.” – Norbert Wiener

“One of the greatest disservices you can do a man is to lend him money that he can’t pay back.” – Jesse Jones

“Debt is like any other trap, easy enough to get into, but hard enough to get out of.” – Henry Wheeler Shaw

“Debt is the secret foe of thrift, as vice and idleness are its open enemies.” -James H. Aughey

“It is poor judgment to countersign another’s note, to become responsible for his debts.” – Bible

“If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours.” – John Maynard Keynes

I wish you freedom from debt soon and financial happiness.