How to Manage Debt
Updated: Jan 26
In our blog about financial wellness last week, we talked about the importance of not having too much debt. This week, we want to explore that idea in a little more detail.
What does too much debt mean to you?
We are all different, and our views of debt will be too. Some people are comfortable having debts, while others would prefer to save up to buy something. However, the latter option is not always practical. For example, most students will take out a student loan and most people who own a property will have a mortgage at some point. (In the UK, mortgages are usually paid off after 25 years. In Switzerland, they last for as long as you own the property.)
Whatever your position, there are a couple of principles that will help you to manage your debt well.
First, always make the minimum or agreed level of interest and repayments. If you don’t, your credit score will be damaged. This can affect you if you want to borrow money in the future, or even if you want to do something as simple as switching your bank account to another provider.
Second, aim to invest at least 20% of your take-home pay in your future – until your bucket is full. If you are struggling financially, it’s OK to start small – investing something in your future is better than investing nothing in it. Start with what you can afford and work up to 20% as soon as you can. In most cases, it is a good idea to make that investment in the following order:
1. Save enough to cover emergencies. This will stop you from being tempted to borrow at high-interest rates if something unexpected happens. Your emergency savings pot should be around six months’ expenditure if you are of working age and twelve months’ expenditure if you are retired.
2. Pay down debt costing more than you are likely to make by investing, starting with the most expensive. Include any debts with an interest rate of more than 10%.
3. Once you have your emergency fund in place and have paid off your expensive debt, it’s time to consider whether you would prefer to pay off your debt with interest rates between 5% and 10% or start to put money into long-term investments. This depends on which option you feel most comfortable with. You might even prefer to do a bit of both. It’s impossible to tell what sort of return you will get from long-term investments. It might be more than the interest that accrues on your debt with these interest rates and it might be less. The tax relief on pensions could make them attractive at this point, and even more so if your employer tops up your own contribution. You will need to do some calculations and make a judgment call.
You might notice that we have not referred to paying off debt that costs less than 5%. This is because you will often find that you can get better returns investing the money than the cost of the interest on the debt. However, again, this is down to personal preference. If you have no debts with a higher interest rate, enough savings to cover emergency situations, and some long-term investments in place, and it will make you feel better to get your mortgage paid off early, then do it.
This is all about your financial well-being for the long term.
Has this article helped you to re-think your strategy for paying down your debts? We would love to hear from you – please leave a comment below or email Keren or Julia, so that we can share your story with others.
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