This is a typical question that many of us ask ourselves once we reach a situation where we have money left at the end of the month rather than a bit of month left at the end of the money. Especially now that interest rates at saving accounts are at historical lows.
This means that it isn’t so attractive for most of us to start saving money when your bank doesn’t pay an interest rate that even comes close to yearly inflation.
Therefore, the typical questions that we might ask ourselves in such situation are:
- Should i pay off student loans or invest?
- Pay off mortgage or invest?
- Pay off car loan or invest?
- Pay off credit cards or invest?
- Should i pay off debt or create an emergency fund first?
Looking at those questions, my general advise is:
Pay off all high-interest debts first, before creating an emergency fund, before investing.
I realize that this is a very simple answer and that it will probably not provide you with enough confidence that this is the wisest thing to do. I understand that, and you’re partially right, because this advise is lacking nuances.
Let me therefore elaborate a bit further on it and provide you with a more nuanced recommendation 😉
Why pay off debt first before creating an emergency fund?
Actually, a quite simple calculation will tell you that it’s better to pay off debt instead of adding to your emergency fund.
Imagine having credit card debt with a yearly interest rate of 14%. Every 100 Euro paid down on that credit card will directly earn you 14 Euro in lower yearly expenses. If you would add that same 100 Euro to your savings account instead, then you will likely not even get 1 Euro of interest paid on your savings account.
Simply said: you are losing money if you are paying more interest on your debt than you’re earning in interest from your savings account.
Having such high interest expenses on debt also justifies paying it off with utmost urgency and not to worry about future unforeseen expenses. The worst that could happen in such situation is to increase your credit card debt again 😉
Personally, I consider any debt higher than 5% as high-interest debt. At least too high for such a low-interest environment.
My recommendation therefore is to pay off all your high-interest debt, i.e.:
- credit card debt,
- car loan(s)
- running line(s) of credit
What about paying off low-interest debt?
Good question! My general recommendation is to not have your mortgage being more than the rule of thumb of 28% of your fixed monthly expenses. This should for instance avoid getting into trouble when your mortgage is getting under water (higher mortgage debt than actual value of the property).
In some countries banks could start increasing the required monthly down-payment due to the increased risk when your house is underwater. A 28% ratio should provide you with some room for such unforeseen circumstances.
I will get back to you later in this post in case you’re monthly mortgage expense is already lower than the 28% threshold.
After paying off all this debt it’s time to build an emergency fund. An emergency fund is a reservation of cash to support you in any unforeseen events. The expenses related to such an event are typically large and dificult to pay from your monthly income without getting into trouble. Examples could be:
- Loss of income due to job loss
- Leakage of your roof, car damage
As a rule of thumb it is recommended to reserve up to 3 – 6 months of cash.
Whether you should consider the low-end or the high-end of that range really depends on your appetite for risk.
I’ve personally built an emergency fund towards the 6 months. We have a large house and the potential expenses related to it in case of an unforeseen could be very high.
I can imagine that you would rather chose the lower end of that range when you have nobody really to provide for and/or if you don’t own any physical assets that might trigger large expenses.
Is your debt under control and is your Emergency Fund created?
Congratulations!!! This is typically where you start to experience for the first time a little bit what financial freedom truly means.
This is the moment that you can be very proud on yourself, because you have already achieved something very remarkable: you created peace in mind, because you have created yourself quite a safety net. This is the time that you can stop looking backwards and focus on the future.
By now you will have income left that you can actually start investing. If you are like me, you might actually notice that your mind starts shifting from a scarcity mindset into a mindset of abundance.
This is truly a great position to be in, so let’s have a look now at what we can do with your disposable income after having paid all your fixed and monthly expenses.
This is also the moment where I would like to come back at the topic of your mortgage. The question now remains is:
- Should I further pay off my mortgage or shall I start investing?
The answer to this question is not an easy one and very personal. In my opinion it comes back again to the topic of your own appetite for risk.
The economic case will probably justify to start investing now. If the stock market historically returned 10% per year and your mortgage is about 4% then it sounds like a no-brainer and start purely investing.
From the other side, being focused on reducing all of your debt first before starting to invest will further lower your fixed monthly expenses, which means even more peace in mind. This has two potential benefits:
- It gives you more freedom in mind and life to make choices that align closer to your passion. I.e. change a job in the corporate world to an NGO and find more purpose in how you spend your time while working.
- It allows you to go more mad on your investments afterwards, because being debt-free provides you more investable income for which you also worry less when you lose some of it. There’s less risk and less guilt, because in the case you lose a part of your investment, you might regret not having used that money to pay-down your mortgage.
So to summarize, both investing or paying down mortgage can logically be justified, but it rather depends, again, on your appetite for risk.
What have I done personally?
The only debt that I have left is approximately 33% of mortgage based on the value of our house.
As per my 2020 goals, it’s my aim to slowly, but steadily pay off the mortgage so that we aren’t confronted with another 21 years of debt, but rather say 12 years. I would really like to prefer not having to include my monthly mortgage payment in my expense calculation for becoming financially independent.
However, I do use a combination of investment and mortgage down-payments.
My first focus is on investing approx 40% of my salary into my dividend growth portfolio. After that, any savings above that rate will go directly to paying off the mortgage. I am expecting to average 10% of monthly income to be allocated to mortgage down payments and on top of it any performance related bonus that I might receive from my employer.
I haven’t calculated yet how quickly it would allow me to pay down the mortgage, but I’m pretty sure that the impact will already be visible after a few years.
That’s all from my side!
Following the simple sequence of paying off your high interest debt first, followed by building an emergency fund should really elevate your wealth. After this you will be in such a luxury position to make financial decisions that can really boost you wealth and change your life fundamentally 🙂
I hope that you found this post helpful and applicable to your own personal situation 🙏
In any case, feel free to get in touch with me or to drop an comment and I will try to get back to you as soon as I can.
I’m not a certified financial planner/advisor nor a certified financial analyst nor an economist nor a CPA nor an accountant nor a lawyer. I’m not a finance professional through formal education. I’m a person who believes and takes pride in a sense of freedom, satisfaction, fulfillment and empowerment that I get from being financially competent and being conscious managing my personal money. The contents on this blog are for informational and entertainment purposes only and does not constitute financial, accounting, or legal advice. I can’t promise that the information shared on my blog is appropriate for you or anyone else. By reading this blog, you agree to hold me harmless from any ramifications, financial or otherwise, that occur to you as a result of acting on information provided on this blog.