King Solomon once said, “The rich rule over the poor, and the borrower is the slave to the lender.”
There’s an important distinction to make when it comes to borrowing though – we need to make the distinction between long-term, lower-cost secure debt (like mortgages), and short-term, high-cost, unsecured debt (like credit cards).
The former, for instance, can be useful to help you during your life, but the latter can be dangerous if you don’t keep it strictly under control. What you have to understand is that taking on too much debt can choke your financial future.
In today’s world, our eyes are often bigger than our stomachs. People finance their cars on Personal Contract Purchase deals or hire-purchase agreements. They will buy their new sofa, kitchen or hot- tub on so-called interest-free credit and it feeds into this culture of instant gratification.
I think the main challenge anyone faces when it comes to borrowing is resisting the temptation to borrow too much and ensuring that we pay and reduce our debts as quickly as possible – and that can be really difficult. Repaying debt enables flexibility and choice in your financial life.
The idea of saving up for something new appears to have disappeared, because everything is available now: you can get something now but pay for it later, usually on these kinds of short-term, high-cost credit. So-called interest-free credit deals are misleading as the cost of the credit has typically been rolled into the cost of the goods you are paying for over 24 months, for instance. It’s this kind of debt that’s expensive, and it’s this kind of debt that you want to avoid much more so than long-term, lower-cost, secure debt, like mortgages.
So, why focus on repaying debt?
The main reason to repay debts is that you can’t create and accumulate as much wealth if you’re having to repay debts.
Sometimes I meet people who are unsure whether they should use some of the money they inherit, for example, to pay off their mortgage or invest the whole sum. I always ask them the same question, “If you had no mortgage, would you arrange a mortgage so that you had money to invest?”
Of course, everyone says “no”. Investing money when you still have a mortgage is the same thing in reverse. If you’ve got a mortgage and you come into money, in general, I would advise my clients to pay off that debt before they consider investing.
When you come into money in that way, you have to look at how to use it wisely and, in the majority of cases, I would say that the wisest thing you can do is pay off debt first. There are some anomalies, but for the vast majority of people the advice is always, pay off debt first and invest second.
So, let’s consider how you can repay debt more effectively?
Once people understand that repaying debt should be their first priority, it’s about finding the most effective ways in which to do that and this is where a wealth planning strategy is required.
Let me give you an example to illustrate what I mean.
A dentists, let’s say, may own their own practice that’s doing really well. They also have a mortgage of around £250,000, which has a remaining term of 22 years, taking them to when they’re 62.
However, they’re hoping to be financially independent by the time they’re 55.
When you’re planning your financial future and considering your lifetime financial position, it’s wise to plan for your mortgage payments to increase annually, either in line with inflation or as a fixed percentage, such as 3%.
I’ve shown this client that if he increases his mortgage payments by 3% each year, he’ll pay off his mortgage by the time he’s 55.
I am often surprised by how many people accept annual increases to all aspects of their expenditure, yet when it comes to their mortgage, they haven’t considered the prospect of repaying their mortgage early by simply making small, incremental increases to their monthly payments each year e.g. £1,200 increasing to £1,236 per month.
What you have to do with longer-term, lower-cost, secured debt like mortgages is assess the outstanding balance and repayments every year. If you can afford to increase your payments by 3% to 4% each year, you can probably take years off your mortgage.
Most people in this position won’t miss a 3% increase each year, just like they don’t miss a 3% increase in their car insurance premium each year. It’s an effective and simple tactic that you can use to repay your debt more quickly. Obviously, it’s important to check with your lender that there are no penalties for making overpayments.
Applying wisdom to borrowing
If you are borrowing, and most of us have to at some point in our lives, it’s important to be wise. Firstly, how much is sensible to borrow? Then consider how many years you are borrowing for.
It’s particularly important to make sure that you’re not taking on too much shorter-term, higher-cost, unsecured debt.
Charles Spurgeon, the famous preacher and author who lived between 1834 and 1892, one said, “No one is so miserable as the poor person who maintains the appearance of wealth.”
We can all fall into the trap of borrowing money though. I’ve done it and even now I question why I purchased my current car using a Personal Contract Purchase arrangement.
Essentially what I’m doing is paying the depreciation, just because I wanted a new car. The key is always making sure that you’re not biting off more than you can chew, but this goes to show that even financial planners can fall into the trap of wanting that instant gratification!
In fact, when it comes to owning a car, there is no ideal solution; however, there are better or worse solutions. In fact, I would suggest the better option is to buy a three-to four-year-old car and replace it when it is seven years old. You only need to look at Auto Trader to see that seven-year-old cars have some value to trade-in against your next three-to four-year-old car.
Of course, owning a new car every three years could be what’s important to you in your life, and therefore your Wealth Plan needs to consider if borrowing is the best way to achieve this.
This is a very different approach to my parents’ and grandparents’ generation, who lived by the motto, “If you can’t afford it, don’t buy it.” It was as simple as that. I can honestly say that, apart from a mortgage and a car loan, my dad and mum never borrowed money. Even with Dad’s car loan, he used it to buy a good quality second-hand car: one that was three years old and that you could be moderately certain of getting three to four years of trouble-free motoring out of.
Whenever you’re thinking of borrowing money to buy something, especially if it’s something you don’t really need, always ask yourself how else that money could be used.
The importance of identifying all your debt
We might have obvious debts in our lives, but there are some things in the modern world that we don’t think of as borrowing, but that are exactly that.
A mobile phone contract is a classic example. If you get a new mobile phone with your contract, then each monthly payment is a form of credit. If you lose or break your phone you still have to pay off that contract, unless you have insurance that covers that eventuality.
It’s a hidden debt in many ways. I regularly come across families who are paying a few hundred pounds a month in phone contracts, and every member of that family is walking around with the latest iPhone.
Changing your mindset around debt
I think that there’s a lot we could learn from my parents’ and grandparent’s generations in terms of how we approach borrowing and debt.
There’s certainly a mindset among this older age group that you shouldn’t borrow money, unless it’s for something like a property. I can’t imagine my parents ever buying something with an interest-free credit deal, and I have many clients who are similar.
These are people who have the wealth to afford the credit and so they could take an interest-free deal with the belief that the money is better in their bank than the retailer’s, but they don’t. There is always the mindset that they have the money and they’d prefer to pay for it right now.
For the younger generation, and I’d include myself in that, the challenge is fighting this desire for instant gratification.
There’s a quote from the Bible that comes to mind in this instance, which is, “We’re all sheep that have gone astray.” It’s a metaphor that Jesus used and when you think about it, it’s accurate. We are like sheep. We just follow one another and we don’t stop and think about whether we’re going in the right direction.
We all have our mobile phone contracts, we get our new cars on PCP deals, we fill our houses with furniture that we’ve bought on interest-free credit, and so on. It’s what everyone does, and I would say that the challenge now is to have self-control, not only around your spending, but more importantly around your borrowing.
It’s also about having awareness about everything that you buy, and being very, very careful not to allow borrowing to choke your financial future.
What to do when you come into wealth
When you come into wealth unexpectedly or suddenly, there can be a danger that you won’t use it wisely.
In these situations, you can get caught up in the idea of investing money, when really you’d be better off clearing some or all of your debt first. The main reason is so that you can prevent debt from becoming the cancer that erodes your wealth.
Think back to what I said earlier about taking out a mortgage to give you money to invest. You wouldn’t do that, so why would you invest before you’ve paid off your mortgage? I’ve met many clients in my time who have come into money and at no point did their previous financial adviser advise them to pay off their mortgage. Instead, they have been encouraged to invest.
When people come to me, they’re often surprised that I focus on a strategy to repay their debt; but as soon as you think about it, it makes perfect sense.
As a general rule, I would say that you should have a strategy to repay debt, particularly shorter- term, higher-cost, unsecured debt, before you try to accumulate wealth.
There are grey areas though, such as pension contributions for higher-rate and additional-rate taxpayers – it’s not an exact science. But even then you have to consider the investment-risk profile and what’s appropriate for each person and family.
In summary, create a strategy to repay debt
If you have debt, your Wealth Plan needs a strategy to repay it. I will always encourage my clients to deal with any shorter-term, unsecured debt, like credit cards, before anything else, because that’s the kind of credit that’s more expensive.
Once you’ve repaid your short-term, higher-cost, unsecured debt, you can look at doing something like the example I gave you earlier, where you increase your mortgage payments by 3% to 5% each year, to reduce the term of your mortgage.
The other key is to make sure that you’re not blind to your liabilities. It’s common for people to look at their assets rather than their liabilities (like debt). They like their savings, and having money for a rainy day is important. However, using some of your savings to repay your debts might not make any difference to your net worth but it will bring flexibility and choice to your desired lifestyle.
Some people see debt as a huge stumbling block and struggle to see how they can manage it, which can make them shy away from dealing with it or talking about it. However, it’s essential to be in control of your debt if you want to start accumulating wealth and planning for your financial future.
If you wish to discuss your financial future or have any questions in relation to this blog, please do not hesitate to contact the Wells Gibson team.