NOTE FROM PEARLER: we do our best to share general resources so you can do your own research. When it comes to tax, this is personal to your investing and financial position. We are not a tax advisor, and don't have any information about your personal situation. This does not constitute financial advice and we would urge you to speak to your financial adviser and/or tax accountant for further information.
What if we told you that a seemingly small $100 debt could accumulate $272,464 in interest over 40 years? That's a fortune that could've been growing in your investment portfolio instead. Can you imagine borrowing more money or selling your shares just to pay for those interest charges?
This financial baggage can affect anyone who's trying to build wealth through long-term investing. It’s like lugging around a bunch of heavy suitcases on a beach holiday. And that’s not exactly the "get rich slow" vibe we're aiming for.
So, if you're wondering what you should do before you start investing, we have the essential checklist for you.
In this week’s episode, we reveal the very real consequences of high-interest debt and highlight how to manage certain types of debt. We share our personal stories of how we cleared our debt and how you can achieve the same success. We also talk about building an emergency fund, bagging the small wins, and figuring out how much you can invest.
The shocking truth about high interest debt
There is “good debt” and “tolerable debt”. Then there’s “really bad debt”. Let’s talk about the latter.
Imagine carrying a heavy load on your back as you embark on your financial journey. That's what high-interest debt feels like. Credit card debt, personal loans, car loans, and consumer debt can weigh you down.
For instance, did you know that the average interest rate for Australian credit card debt is a staggering 19.94%? Personal loans aren't far behind, with an average interest rate of 10.02%. These numbers may seem small at first, but let's unravel the long-term consequences.
On just a $100 debt, the interest alone would accumulate to:
- $623 over 10 years
- $5,121 over 20 years
- $37,625 over 30 years
- an astonishing $272,464 over 40 years.
Australians collectively owe a staggering $17.73 billion in credit card debt as of March 2023. That's a lot of hard-earned money tied up in interest payments. And just to add to the misery, most credit card interest is compounded daily. This means the actual interest you end up paying can be even higher.
Now, here's a fundamental principle to remember. Compound interest is a magical concept when it comes to investing. But compound interest can also work against you if you're on the paying end. We're all about leveraging the power of compounding to grow your wealth. However, when paying off debt, it's a different story.
Why paying off your debt should be a priority
Clearing your high-interest debt can offer you a guaranteed return. Think about it—if you pay off the debt, you won't have to worry about shelling out those hefty interest payments ranging from 10% to 19%. The significant amount you get to save is a return in itself that you can count on. This is unlike investing, where returns can never be guaranteed, and market volatility can impact your earnings.
Let's break it down with a simple example.
Say you have a $100 debt with a 10% interest rate. If you manage to pay it off before interest accrues, you save yourself $10. On the other hand, if you were to invest that $100, you might make, for example, a 7% return in a year. However, there's also a chance you could lose 7% due to the unpredictable nature of the stock market. It's a risk you need to consider.
Additionally, when it comes to investment income, don't forget about the taxes you'll have to pay on your earnings. That's another factor to keep in mind as you weigh your options.
Is mortgage considered a high-interest debt?
Now, let's address a common question—does high-interest debt include mortgages?
The answer is no, not all debts are created equal.
Personal loans, also known as consumer debts, are different from mortgages. Personal loans often involve depreciating assets—things that go down in value. On the other hand, mortgages are debts tied to generally appreciating assets, such as a home that tends to increase in value over time.
Picture this: a holiday you took to Greece three years ago isn't going to make you any money. However, a mortgage has the potential to help grow your wealth or provide you with a place to live. This is why some people prioritise paying off their mortgages instead of investing, especially when interest rates are higher.
Here’s another hypothetical scenario. If you have a mortgage with a 6% interest rate, it becomes a tougher decision between investing or paying off the mortgage. After all, the S&P 500, which represents the top 500 US companies and is a key benchmark in investing, has averaged a 7.33% return over the last 20 years.
However, when it comes to high-interest debt, the choice becomes crystal clear—paying it off is undeniably more beneficial.
Understand HECS-HELP debt
Imagine your HECS-HELP debt as a mortgage, where the maths seems somewhat similar. However, there are a few intriguing considerations that set the two debts apart.
To start, let's examine the interest rates. HECS-HELP debt is indexed at 7.1% in June this year. Now, that's higher than what you'd typically find with most mortgages or even savings accounts in today's market. The higher interest rate may leave you wondering about how it affects your financial situation.
However, there's more to HECS-HELP debt than meets the eye. So let's explore the factors that set it apart from other debts.
One thing to remember is that you only have to make repayments when you're earning over $48,000 a year. That's right—no need to stress if you're just starting out or working part-time. HECS-HELP repayments are income-based, so they adjust to your financial situation. It's a bit different from other debts out there, where you're stuck with a fixed amount to repay each month.
There’s also a kicker: once you've made those repayments, there's no going back. It's not like a mortgage where you can build up equity or refinance if you want to make a change. Even if you find yourself unable to continue studies, the repayments you've made so far can’t be reclaimed. So, it's important to think it through and consider all your options before making repayments.
How Tash and Ana pay off their debts
Do you feel the weight of debts pushing you further away from your dreams? It's a scenario many of us can relate to. In Australia, the Credit Default Risk of Aussie consumers has shot up by over 8% this year. Rising interest rates, soaring consumer goods prices, and exorbitant rental costs have all contributed to this mounting burden.
So, how did we personally manage to break free from the clutches of debt? Our stories highlight some key principles if you’re looking to pay off your debts and move towards financial freedom.
Master the Credit Card Game
Credit cards can be a double-edged sword. While they offer convenience, they can also lead to high-interest debt if not managed carefully. From our experience with credit cards, paying off the balance in full each month has benefitted us. This habit prevents interest charges from piling up and fosters a healthy relationship with credit.
Tackle debts first
Take a page from Ana's playbook and confront your debts that are just sitting there. Develop a repayment plan and focus on eliminating the high-interest debts first. This way, you can minimise the overall interest paid and accelerate your path to debt freedom. Remember, small steps can lead to significant progress.
Optimise mortgage payments
When securing a mortgage, consider the interest rate structure. Tash's choice of a fixed-rate mortgage provides stability and predictability for effective budgeting. It allows her to ease the debt burden and set aside more money for investing.
Avoid taking on unnecessary debt
Tash's careful avoidance of car loans or personal loans shows how conscious spending can actually fast-track your way to wealth. Before getting any loans, question whether you really need it. Is getting a loan your only option, and does it align with your financial goals? By minimising unnecessary debts, you'll be in the best position to invest more money and collect bigger gains later on.
Save an emergency fund
You're cruising along, enjoying life, when suddenly a storm hits. Your car breaks down, or your roof caves in, or you lose your job. Life's unexpected emergencies can throw us off balance. What do you do?
An emergency fund is like your financial safety net. It’s a stash of cash tucked away, solely for those "oh, no!" moments life likes to throw at us. Without enough emergency funds, you might be tempted to take on debt to cover those unexpected expenses. As a result, you’d have to pay hefty interest charges for a long time, and you may never be able to invest at all.
An emergency fund is also a must-have foundation so you can hold onto your investments for a long time. Because here's the thing: the sharemarkets can be a bit like a wild rollercoaster ride. They go up, they go down—depending on many factors outside our personal control. And the last thing you want is to be in a position where you're forced to sell your investments to handle an emergency.
You only truly lose money in investing when you sell your investments during a market dip. To be a superstar at long-term investing, you have to dodge those situations altogether. Aside from the potential losses you might face, selling investments can also have tax implications. That's why being prepared with an emergency fund is an absolute must to survive rocky times and potentially save you money on taxes.
How much should you have to prepare for emergencies? Well, the general rule of thumb says your emergency fund should cover 3-6 months' worth of living expenses.
But there are a few things to consider that might sway that number:
- Dependents Do you have family members or loved ones who rely on your financial support? If so, it's smart to have a bigger emergency fund to cover their needs when the unexpected strikes.
- Property ownership Buying a property as a long-term investment can go with owning shares. But when those emergency repairs come knocking, they can hit you in the wallet. Keep that in mind when figuring out your emergency fund size.
- Job security and marketability Take a good look at your job security. If you're rock solid in your current gig, you might be able to get away with a smaller emergency fund. But if your job's as shaky as a Jenga tower, you'll want a bigger cushion.
- Supplementary income Do you have any extra income streams? Having alternative sources of income can be a backup plan. That way, you won’t have to build bigger emergency funds for when the unexpected happens. In Episode 14, we explored how you can increase your income and add more sources of cash.
- Life changes Planning on going on parental leave or welcoming an addition to the family? Those joyous occasions might need some extra expenses, so adjust your emergency fund accordingly.
- Travel considerations Do you have family living interstate or overseas? You'll need to consider potential flight costs when emergencies strike.
- Insurance assurance While your emergency fund is a lifesaver, having the right insurance coverage can add an extra layer of security to your financial moat.
Remember, everyone's money situation is as unique as a fingerprint. A university student living it up at home with minimal bills will have a different-sized emergency fund. It’s an entirely different story for a family with kids and relatives scattered across the globe. So, take a good look at your own circumstances and build your emergency fund around that.
To bring things down to a personal level, let’s look at Ana’s emergency fund. Ana used to have an emergency fund of around $20,000. However, she recently downsized to a $5,000 emergency fund. Why? Well, life's all about choices, right? Despite the change, Ana knows that having a safety net in place is crucial to protect her financial future.
Break down big investment goals
In our first episode, we talked about how investing in shares can be a good long-term investment strategy (think seven years or more). But here's the scoop: shares might not be your go-to for short-term goals like saving up for that dream holiday or hustling for a wedding just around the corner. Timeframes matter when you invest.
With that said, investing is a journey that stretches on and on, demanding a lot of patience and determination. And let's be honest, sometimes investing itself doesn't light our fire. But investing with a purpose? That's where the real magic happens.
You're not just investing to check it off your to-do list, but to achieve financial freedom. We're talking about the day when you can flip that "work optional" switch. Imagine the moment you finally say goodbye to toxic environments for good.
But wait, let's bring it back down to earth. Let's say you have a specific goal in mind—saving $50,000 for a house deposit within the next five years. Instead of saving or investing without a plan, bag the easy wins that lead to a big life goal like homeownership. When they add up, your easy wins can give you the motivation to continue while keeping it sustainable.
It's like finding small, colourful flags strategically placed amidst the towering trees. Each flag represents a small achievement, a mini-victory that propels you closer to the ultimate milestone. Trust us, it’s not impossible to tackle any financial goals when you have a clear roadmap like this.
Episode 2 will give you a more in-depth exploration of different investment options and which ones suits your goal horizons best. Give it a listen after this episode.
Figure out how much you can invest
When investing, one of the first things you need to figure out is how much you can actually invest. It's like knowing how much you can spend on that new pair of shoes without breaking the bank. You wouldn't want to go all-in and end up short on cash for everyday expenses.
To get a handle on your investing potential, it's time to take a good look at your cash flow. No, we're not talking about summoning your inner accountant. Just track your spending and see where your hard-earned cash is flowing.
If that sounds like too much work, you can create a simple budget to allocate funds for your everyday expenses and investments.
Now, don't go overboard and be too strict on yourself. We believe investing is all about striking a balance between building your wealth and enjoying life. We want you to develop smart, long-term habits that stick with you for a long time. Think of it as a financial diet and exercise routine—keep it healthy, sustainable, and manageable for the long haul.
Remember, building wealth is about learning to play the long game. As Warren Buffett said, “the stock market is a device for transferring money from the impatient to the patient.” And, in our current context, investors tend to do better when they can afford to be patient.
You'll want to let your money ride the waves of the sharemarket without panicking. That's why it's advisable to invest your money for at least seven years or more. Keep in mind that the money you invest shouldn't be earmarked for short-term goals or emergencies.
Questions from the community
Recently, we reached out to the community through our GRSC Instagram account and asked them what they did before they started investing. We received some insightful responses that we can't wait to share with you in this article.
Pay off your consumer debt, including Buy Now, Pay Later (BNPL)
Our community had one thing in common—they urged everyone to kick debt to the curb before diving into investing. This means addressing any high-interest debts that might be weighing you down.
But there's one more thing to consider: Buy Now, Pay Later (BNPL) services like Afterpay. While these interest-free platforms may appear enticing, it can become a slippery slope. Before diving into investing, establish healthy financial habits and break free from relying on these tools. Focus on eliminating debts and creating a solid financial footing.
Jot down your intentions
Knowing your "why" is a powerful force that will drive your investing journey. Take a moment to reflect on your intentions and write them down. What are your goals? Where do you envision yourself in the future?
By putting your intentions on paper, you create a roadmap that keeps you on track as you navigate the world of investing. The long-term commitment to investing requires clarity and a clear vision of what you try to achieve.
Do your research, but don’t get trapped in analysis paralysis
Doing your own research can boost your confidence and make you more comfortable about the risks involved in investing. However, falling into the trap of "analysis paralysis" can hinder your investing progress. It's great to consume all the podcasts (especially ours—hint, hint) you can find, but don’t forget to take action. Remember, investing is also a learning-by-doing experience.
Take action this week
Just like preparing for any journey, investing requires some groundwork too. And what's the most important thing to do before setting off? Make sure you have everything in order so that nothing crashes your progress or stops you from investing altogether.
So, as we wrap up this episode, here’s a checklist of things you must do before investing.
First, prioritise paying off any high-interest debt you may have. Next, make sure you have an emergency fund that will protect you from unexpected expenses or financial setbacks. Third, take the time to define what you want to achieve through investing. Finally, assess your financial situation and determine how much you can comfortably invest.
Already on your investing journey? Spread the wealth by sharing this episode with a friend who's just starting out. Helping others embark on their own path to financial independence is a rewarding experience. You never know how much of an impact you can make on someone's life.
Happy investing!
Tash & Ana
