4 important things to consider before paying off your debts

4 important things to consider before paying off your debts

So you have some money left over after paying the necessary bills. That's good news. But should that money go toward investments or toward reducing your debt?

It's not a simple answer, and it depends on what you owe, how much you owe, and what your investment plans are. Here are some general guidelines on whether to invest your extra cash, or pay down your loans.

1. Always keep cash on hand for emergencies

Do not fully empty your bank account in order to pay down debt or invest. Always keep some cash on hand for emergencies.

A common rule of thumb is to build and maintain an emergency fund, of about six months of your income, before making decisions like whether to invest or accelerate loan repayment.

If you do not have any money and are faced with an emergency, you will often end up taking a loan. This defeats the purpose of you rushing loan repayment and it may cause premature liquidation of your investment assets.

For example: Say you owe $10,000 to the bank which you are supposed to repay over five years. However, you currently have $8,000 on hand and you decide to accelerate repayment. Instead of following the repayment scheme and paying a few hundred a month, you pour all $8,000 into reducing your debt. Now you owe just $2,000.

But what happens if you get into an accident and need money for treatment? You have no money on hand, because you dumped all of it into debt reduction. This results in you taking another loan and you're back to square one.

Now what about investing?

Consider what would happen if you put all $8,000 into shares and you need the money to deal with an emergency. Instead of taking on another loan, you decide to sell some of your shares to get some money back. But you can't always rely on selling your shares at a higher price than you bought them. If you are in a market downturn, your $8,000 worth of shares may only be worth $5,000 at the moment. This would cause you to lose money.

For these reasons, you should never completely empty your bank account either for investments or to reduce debt. But once your emergency fund is built, you can consider the following:

2. Compare the interest rate on your loans to the returns from your investments

With the exception of a mortgage, it is quite difficult to "out-invest" on the interest on loans.

Credit cards, for example, have an interest rate of around 24 per cent per annum. It is almost impossible to beat this interest rate with your investments; achieving returns of even ten per cent consistently is a challenge, so your credit card debt will snowball much faster than you can grow your investments. This means that, if you have credit card debt at all, you should definitely pay it off before investing!

Next we have personal loans, which range between six to nine per cent interest per annum. Unless you are very aggressive and successful, it is still hard to beat this interest rate with investment returns. Passive investments, such as in an index fund, might net your returns of five to seven per cent per annum on average. So if you want to save money in the long run, it might be a good idea to pay down your debt before you invest.

However, watch for prepayment penalties! Some banks have additional charges if you try to pay off these loans prematurely. If the penalties are too steep and impact your cash flow, reconsider attempts at prepayment.

With regard to your mortgage, it is usually better to pay off the mortgage at the end of the loan tenure and invest the money instead. HDB concessionary loan rates are just 0.1 per cent above the CPF Ordinary Account rate (2.6 per cent per annum at present), while most private bank loans are around 1.8 per cent per annum. (If you are using a private bank loan, your CPF already grows faster than your mortgage interest rate!)

It is not difficult to beat returns of 1.8 per cent or 2.6 per cent; even the worst performing insurance policies can usually net you returns of at least three per cent per annum.

You can find loans with the cheapest interest rates by comparing them on SingSaver.com.

3. Consider your cash flow issues if finances are tight

So far we've talked about interest rates. But it's also important to deal with cash flow. Eliminating a loan that increases cash flow can provide more money to invest.

Say you have two different loans. Loan A has an interest rate of 7 per cent per annum and costs you around $200 a month in repayments. Loan B has an almost similar interest rate, say 7.5 per cent per annum but it costs you around $300 a month in repayments.

By paying down Loan B, you instantly free up $300 a month that you can use to invest - even if its interest is 0.5 per cent more than Loan A. You can also use this approach if you are cash strapped and just earned a temporary windfall you can use to pay down debt. When the difference in interest is small, consider paying off the one that frees up more cash.

4. Keep to your debt servicing ratio (DSR)

Your debt servicing ratio (DSR) is the ratio of your monthly repayments to your monthly income.

For example, if you earn $4,000 a month, and you spend $2,000 in loan repayments, your DSR is 50 per cent. A healthy DSR, before factoring in your mortgage, should be 50 per cent or under. (As an aside, the bank measures your DSR before deciding on the size of your home loan. You will not be given a mortgage if the total repayments, including other loans, raise your DSR above 60 per cent.) Your DSR can also be an indicator of when to invest. If your DSR is above 50 per cent, you should focus on reducing your debt before investing.

The Fifth Person is a digital investment magazine that publishes the latest investment news, stock analyses, AGM reports, and financial education.
Visit The Fifth Person to learn more and how to make smarter, more profitable investment decisions.

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