True or false, reducing debt is an investment in the future?

27 August 2015

It’s hard to argue with the logic that debt is an inevitable by-product of a modern day lifestyle. When you’re caught between servicing the mortgage, taking time out to raise the kids, covering daily expenses and obtaining that ‘occasional’ and rare treat, debt may seem like an inescapable reality.

You may wonder however, if there’s a better way to manage it all. Do you pay off debt with any spare change you may have, or do you invest that money? What strategies will achieve greater results?

To work out which is best for you – to pay off debt or put your money into investments, like savings or buying shares for example - here are three questions that might help you shed some light on your situation:

What kind of debt are you contending with?

If you’re paying off a mortgage, that’s debt, but it is also an investment in your future.

Credit cards, store cards and hire purchases - or any other debt - with interest rates of between 13 and 25 per cent however, may be a drain because the interest rates are likely to be higher than most investments will earn before taxes.

Therefore, if the interest rates on your debt are higher than any investment returns you may earn, it is worth considering putting your spare cash into eliminating the debt. As in all things though, it is best to seek expert financial advice.

If you have a debt that is costing you 20 per cent interest and you pay that debt off, consider it a 20 per cent return on investment.

What is your debt-to-income ratio?

According to Investopedia, your debt-to-income ratio is a comparison between how much money you earn compared to how much you owe creditors, and is one of the measures lenders use to measure your credit worthiness.

“A debt-to-income ratio smaller than 36% (e.g. your debt totals 36% of your income) however, is preferable, with no more than 28% of that debt going towards servicing a mortgage,” Investopedia says

If your debt-to-income is too high, then you might want to consider investing in debt reduction simply because a high debt-to-income ratio puts you into a financially vulnerable position. At the very least, it may affect your ability to get credit in the future.

To summarise, the New Zealand Commission for Financial Capability puts it this way: “Which would be better for your finances – paying down the debt that you have or investing in shares? Even before knowing the details of an investment, we can already say that to be worth it, the returns from the investment would have to be greater than the amount of interest you are paying on your borrowings. That’s a big ask.”

Find out more about the investment options available with AMP.

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