People who have debt - and when I say debt, I am referring specifically in this article to debt that is less than €15,000, such as credit card balances, personal loans, credit union loans and so on - ask me all the time, whether they should concentrate all of the surplus money they have left over each month to pay down this debt, so it is repaid in full as fast as possible.
They want to know is this the right thing to do rather than paying off their debt along with putting some money into a pension or savings plan as well.
So, the question is, should you only focus on your debt and forget about everything else until it is paid off in full?
There are two schools of thought, in the financial world about which is the best route. Some say yes, use whatever money you have to get rid of your debt and once it is repaid in full, you can then catch up on your pension and savings account.
Others say no, that is the wrong thing to do, you should split your money into savings and loans account at the same time and don’t choose one over the other.
I wanted to have a closer look at both to see which one makes more financial sense.
Those who say just focus on your debt put forward the argument that you should concentrate all of your efforts on just one thing, focus on nothing else but completing it and only when this happens should you move on to other tasks.
Because, they argue, if you try to do everything all at once you will simply fail; that is their experience.
They say it will fail because if you try to focus on everything at the same time i.e. paying off debt, saving, paying into your pension etc. progress becomes very slow.
Paying a little over your minimum loan repayment each month, a little overpayment on your mortgage, 1% of your salary into a pension fund and so on, just dilutes your efforts because you are trying to cover each area and it takes you forever before you finish anything.
What happens then is that you feel you are getting nowhere, which is dangerous because if you feel this way you think all your efforts are for nothing and you become tired and just give up.
The power of focusing on one task is that things begin to happen quicker, you can see the visible results of your efforts.
Focus exclusively, they say, on paying off your debt even if seems to be to the detriment of other areas of your finances, as long as you concentrate as much on them as you did on getting out of debt.
One important point to worth noting is that people with this point of view always insist that people do have some sort of an “emergency fund” in place first.
A very popular financial “guru” in the States, Dave Ramsey, argues that people should first aim to have a small amount of money in an account they can call upon if an unforeseen event occurs.
He suggests that once you have €1,000 in your account, you are ready to tackle your debt and not until all of your debts are repaid in full should you begin saving for retirement or putting money into your child’s educational fund.
My gut tells me he is absolutely right but let’s give the other side a chance, and then we can start crunching the figures.
Ignoring your retirement or savings account by devoting all of your resources to paying off your credit cards or personal loans, others argue, most notably the best-selling author of ‘Start Late, Finish Rich’, David Bach, virtually guarantees you will stay in debt forever.
Bach says that the number one reason people are unable to, or put off, saving for the future is because they choose to repay their debt over saving. This, he says, is a huge mistake.
He points to how large companies handle their debt. They don’t devote all of their income to paying it off, yes they allocate a portion of their resources to paying off their debt but at the same time, they use some of their income to developing new products/markets and are all the time trying to expand and grow their business. I understand where people who propose this strategy are coming from. Because it is important to know from an emotional point of view that whilst you are paying off debt, at the same time you are saving for the future. By doing both together at the same time, you feel you are making progress.
Having listened to both points of view, I wanted to strip away the emotion of each argument and look at the cold hard figures and see which makes better financial sense.
To find out the answer, and for the purpose of this exercise, I am going to use an example of a 40-year-old male, who is earning c. €30,000 per year. He has credit card debt of €8,000, has no pension in place and the maximum amount he can afford to repay towards debts or use for savings is €200 each month.
If he splits the €200 per month and opts to repay his credit card €160 each month and €40 into his pension, this is what would happen:
It would take him about nine years before his debt would be repaid in full. And he would have paid €9,344 in interest to his credit card provider
He would accumulate a pension fund of €88,913 when he reaches 65
By using all of his money to eliminate his credit card debt and not put anything into his pension until it is repaid in full and then when the debt is repaid in full, switch it towards his pension, the following would happen:
It would take him five years and six months to clear his credit card in full and he would have paid €5,293 in interest payments.
He would have accumulated €121,056 in his pension fund having switched his attention to that earlier.
So, it is quite clear to me in this instance and many others that you will be financially better off focusing on clearing your debt first before you do anything else.
In the example I have just shown, you can see that you would have paid nearly 50% less in interest to your credit card company and have 35% more in your pension fund.
Remember the best way to eat an elephant is one bite at a time. If debt is your elephant, focus on that and nothing else until it is repaid in full.
Then and only then should you move on to other areas of your financial life – the numbers prove this is the best outcome for you.