Paying off high-interest debts, such as credit card balances, is one of the most effective ways to secure long-term financial health. Although investing early is often encouraged, carrying high-interest debt can seriously hinder wealth-building efforts.
This
article explores why eliminating high-interest debt should come before making
investments and offers a clear path to follow.
1. The Hidden Cost
of High-Interest Debt
High-interest debt, particularly
from credit cards, can accumulate quickly due to compounding interest. Many
credit cards have annual percentage rates (APRs) between 18% and 30%. When left
unpaid, the interest continues to grow, increasing the total amount owed each
month.
For example, someone who carries
a £5,000 balance on a credit card with a 25% APR and only pays the minimum each
month may take years to repay the full amount. During this time, hundreds or
even thousands of pounds could be lost in interest alone. This expense can
severely limit available cash that could otherwise be used for savings or
investment.
Even if investments are earning
decent returns, he often fail to match or exceed the cost of high-interest
debt. For instance, a stock portfolio may generate an average annual return of
7%, but this is significantly less than the 20% interest accumulating on a
credit card balance.
2. Why Paying Debt
Is a Guaranteed Return
Investments come with risk, while
paying off debt offers a guaranteed financial benefit. Reducing or eliminating
a 20% APR credit card debt is equivalent to earning a 20% return on an
investment—without any market risk.
This comparison is often
overlooked. Many financial decisions focus on growing wealth through
investments, but this approach fails to consider the guaranteed
"return" of paying down high-interest obligations. It's similar to
earning money simply by not losing it to lenders.
Take the case of Jenny, who had
£6,000 in savings and an equal amount in credit card debt. Instead of investing
the savings, she used them to eliminate the debt. By doing so, she effectively
gained a 22% return, equal to the card’s APR. If she had invested instead, even
a good year might have yielded only 8–10%, while interest on the card would
have continued to compound.
3. Psychological
Benefits of Being Debt-Free
Becoming free from high-interest
debt brings more than financial gains. It also provides significant mental and
emotional benefits. Carrying high debt often leads to stress, anxiety, and
difficulty concentrating on long-term goals.
A person who is constantly
worrying about making minimum payments is unlikely to focus effectively on
financial growth. Once this burden is lifted, energy and attention can be
redirected to saving, investing, or even pursuing personal goals.
Additionally, being debt-free boosts financial confidence. This increased sense of control can encourage healthier financial habits, such as budgeting, tracking spending, and prioritizing long-term objectives like retirement or home ownership.
4. How to
Prioritize Debt Repayment Before Investing
The process begins with
identifying and listing all outstanding debts, ranked from highest to lowest
interest rate. The most urgent debts—typically credit cards or payday
loans—should be addressed first.
The "avalanche method"
is an effective strategy. This involves paying the minimum on all debts while
putting extra funds toward the debt with the highest interest rate. Once that
is paid off, the focus shifts to the next highest, and so on.
Alternatively, the "snowball
method" prioritizes paying off the smallest debt first, which can provide
a quicker sense of accomplishment. Although this approach might not save as
much in interest, it can be helpful for staying motivated.
While paying down debt, it's
still wise to maintain basic financial protections. Keeping a small emergency
fund—ideally £500 to £1,000—can help avoid relying on credit cards for
unexpected expenses.
5. When to Start
Investing After Paying Off Debt
Once high-interest debt is
cleared, attention can turn to building wealth through investing. This is the
stage when investing becomes truly effective, as any returns earned are not
being offset by costly interest payments elsewhere.
With the financial burden of
high-interest debt removed, surplus income can be allocated toward retirement
accounts, stocks, or mutual funds. At this point, the full power of compound
interest can be utilized without the interference of ongoing debt.
It is also a good time to
reassess financial goals. Creating a diversified investment portfolio,
increasing savings contributions, and exploring long-term planning
opportunities can now become the primary focus.
Conclusion
Paying off high-interest debt
first, especially credit card balances, is a crucial step in creating a solid
financial foundation. It delivers guaranteed returns, reduces stress, and
positions individuals for future investing success. Although investing is
essential, it should come after expensive debt has been addressed. In this way,
financial decisions become more efficient, effective, and rewarding in the long
run.
Frequently Asked
Questions
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