It’s one of the most commonly asked questions of those seeking help with improving their finances. It’s a trick question. The fact is, paying down debt is an investment, in fact, everything you do with your money is. The only question is what the returns will be on the investment choices you make with your money.
Everything you do with your money from spending and saving to giving and gambling causes you to become either wealthier or less wealthy. However, debt reduction is one of the best investment decisions you can make, because every cedi of debt you eliminate frees up funds for saving and investing in assets that can appreciate and earn interest for you. And if you’re being charged interest on your debt burden, as the overwhelming majority of us are, debt reduction is the only investment with guaranteed returns.
Most of the money used as a medium of exchange in Ghana is created by banks when they make loans. The only way to get extra money into the economy is to borrow it from banks, leaving us all trapped under a mountain of personal debt and mortgages.
The Problem
Banks create new money when people go into debt
When you take out a loan, new money is created. As people borrow more, more new money comes into the economy. All the extra spending this newly created money funds gives people the impression the economy is doing well, which encourages them to borrow even more. As the debt goes up, so does the amount of money.
For every cedi of money, there’s a cedi of debt
Because banks create money when people borrow, for every cedi of money in the economy there will be a cedi of debt. If there’s GHC 100 in your bank account, someone else must be GHC 100 in debt. Across the whole economy there will be as much debt as money.
If we want more money in the economy, we have to go further into debt
If we need to get more money into the economy for example, during a recession – then we have to go further into debt to the banks. This is why the government is desperate to get banks’ lending again: if banks start lending more, they’ll create more new money in the process, and the people who borrowed will spend this new money. But the most controversial question is if the financial crisis was caused by people having too much debt, how can the solution be for people to take on more debt?
If we try to pay off debt, then money disappears
When you pay down your debts, the money that leaves your bank account doesn’t go to anyone else – it just disappears. This is because loan repayments are just the opposite process to money creation: banks create money when they make new loans, and effectively ‘destroy’ money when they repay loans.
So when lots of people try to pay down their debts at the same time, money disappears from the economy. As a result of there being less money and less new lending spending slows down. When this happens, it’s like draining the oil from the engine of a car: pretty soon, everything stops working.
This means that it’s almost impossible to reduce our debts without causing a recession. And you personally can only pay off your debts using money that was created when someone else went into debt. This creates a debt trap, where over time the level of personal debt in the economy has to keep growing.
How To Invest When You’re Deep In Debt
It’s natural that if you have some money saved or invested, you want to see it grow. There are many factors that can prevent this from happening, but for many people, one of the biggest obstacles is debt. If you have debt to deal with – be it a mortgage, line of credit, student loan or credit card – fear not; you can still learn how to balance your debt with saving and investing.
Types of Debt
Generally speaking, having debt can make it very difficult for investors to make money. In some cases, investing while in debt is like trying to bail out a sinking ship with a coffee cup. In other words, if you have a debt on your line of credit at 7% interest, the money you are investing will have to make more than 7% to make it more profitable than simply paying down the debt. There are investments that deliver such high returns, but you have to be able to find them, knowing you are under the burden of debt.
It is important to briefly distinguish the different kinds of debt here:
High-Interest Debt – This is your credit card. High interest is relative, but anything above 10% is a good candidate for this category. Carrying any kind of balance on your credit card or similar high-interest vehicle makes paying it down a priority before starting to invest.
Low-Interest Debt – This can be a car loan, a line of credit or a personal loan from a bank. The interest rates are usually described as prime plus or minus a certain percentage, so there is still some performance pressure from investing with this type of debt. It is, however, much less daunting to make a portfolio that returns 12% than one that has to return 25%.
Tax-Deductible Debt – If there is such a thing as good debt, this is it. Tax-deductible debts include mortgages, student loans, business loans, investing loans and all the other loans in which interest paid is returned to you in the form of tax deductions. Because this debt is generally low interest as well, you can easily build a portfolio while paying it down.
The types of debt we will cover in this article are long-term low-interest and tax-deductible debt (such as personal loans or mortgage payments). If you don’t have high-interest debt or, better yet, all your debts are tax deductible, then read on. If you do have high-interest debt, you’ll need to pay it off before you begin your investing adventure.
Why Invest?
Debt elimination, particularly of something such as a loan that will take long-term capital, robs you of time and money. In the long term, the time (in terms of compounding time of your investment) you lose is worth more to you than the money you actually pay (in terms of the money and interest that you are paying to your lender). You want to give your money as much time as possible to compound. This is one of the reasons to start a portfolio in spite of debt (but not the only one). Your investments may be small, but they will pay off more than investments you would make later in life, because these small investments will have more time to mature.
The Plan
Instead of making a traditional portfolio with high and low-risk investments that are adjusted according to your tolerance and age, the idea is to make your loan payments in the place of low-risk and or fixed-income investments. This means that you will be seeing “returns” from the lessening of your debt load and interest payments rather than the 4-8% return on a bond or similar investment. The rest of your portfolio should focus on the higher-risk, high-return investments like stocks. If your risk tolerance is very low, the bulk of your investing money will still be going toward loan payments, but there will be a percentage that does make it into the market to produce returns for you.
Even if you have a high risk tolerance, you may not be able to put as much as you’d like into your investment portfolio because, unlike bonds, loans require a certain amount in monthly payments. Your debt load may force you to create a conservative portfolio, in that most of your money is being “invested” in your loans with only a little going into your high-risk and return investments. As the debt gets smaller, you can adjust your distributions accordingly.
You can invest in spite of debt. The important question is whether or not you should. The answer to this question is very personal. There is no denying that there can be benefits from getting your money into the market as soon as possible, but there is no guarantee that your portfolio will perform like it needs to. Such things depend on how adept you become at investing.
The biggest benefit of investing while in debt is psychological (as much of finance is). Paying down long-term debts can be tedious and disheartening if you are not the type of person who puts your shoulder into a task and keeps pushing until it is done. For many people who are servicing debt, it seems like they are struggling to get to the point where their normal financial life – that of saving, investing, etc. – can begin. Debt becomes like a Chinese movie where things seem to be happening in slow motion. By having even a modest portfolio to distract you from the tedium, you can keep your enthusiasm about your finances from ebbing. Knowing that the sun will come up and being able to see the dawn are very different experiences. For some people, building a portfolio while in debt provides a much needed ray of light.
Investors face the dilemma of whether to pay down debt with excess cash or to invest that money in an attempt to turn it into even greater amounts of wealth. If you pay off too much debt and reduce your leverage, you may not garner enough assets to retire. Conversely, if you’re too aggressive, you may end up losing everything. In order to decide whether to pay down debt or invest, you must consider your best investment options, risk tolerance and cash flow situation.
Author: Gabriel Ofori Yeboah
Fund Manager, Investor, Broker, FX Trader, Consultant–(Investment, Financial Analyst, Banking)
Email: gabbynanaoforiyeboah@gmail.com
Tel: 0246751535