The Balanced Debt Diet
Conventional wisdom says people who owe money should focus on repaying their debt before they save their cash. But is this strategy always the best course of action? Why it may sometimes make sense to set aside money, even if you have debts?
Good debts versus bad debts
Most people do not like being in debt, but it is important to understand that there are good debts and bad debts.
A mortgage would be classified as a good debt, as it provides a way of acquiring a substantial asset. Very few people could afford to buy a property in cash, and interest on a secured loan is typically one of the cheapest forms of borrowing.
Meanwhile, by living in a property you own, you are saving money on rent. In other words, mortgage debt helps you improve your financial position in the long run. By contrast, bad debt is a drain on your finances. For example, double-digit interest is usually charged on credit card debt. You have nothing to show for your money once you have repaid the debt, and the fact that you built it up in the first place is often a sign that you were overspending.
The conventional approach
Having taken a look at your debts and decided which ones are good debts and which ones are bad ones, people are often told to use all of their spare money to repay the bad debt as quickly as possible, starting with the borrowings that charge the highest interest rate. It is generally advised that only once you have repaid all of your bad debts, should you start thinking about using your spare cash to save money.
The argument goes that as the interest you are charged on debt is nearly always higher than the interest or returns you can earn on savings and investments, your money works hardest for you if you use it to pay down these debts.
The balanced debt diet
But is this always the best course of action? Say you have a student debt of HK$200,000, even if the interest on the debt is low, it could take you several years to repay it. By the time you hit 30 you may be debt free, but you also have no savings, no deposit to get on to the property ladder and you have not yet started to set aside money for your retirement. You may also have added to your debt along the way.
Alastair Ward, head of customer savings proposition at Standard Life Aberdeen, puts forward a different approach to repaying debt, which he has dubbed the balanced debt diet.
He said instead of using all of his spare cash to repay debt, he split his money into different pots, using half of it to repay debt, a quarter of it for short-term saving, and a quarter for long-term investing. He says the advantage of this strategy was that while he was still reducing his debt, albeit at a slower rate, he was starting to build up savings at the same time.
Pros and Cons
Ward points out that his approach would not suit everyone and it does come with some downsides. Because interest on debt is nearly always higher than that on savings, following his scheme is likely to be more expensive in the long run. Being in debt for longer may also have a negative impact on your credit rating, while it could impact your ability to borrow money for good debts, such as a mortgage.
But there are also a number of positives to his approach. By starting to build up savings, Ward was developing good financial habits and he had an emergency fund he could use for unexpected expenses, meaning he was no longer adding to his debt. By investing money for the long-term, he was also building solid financial foundations for retirement. He also says that while he still has some debt, he feels in control of his finances.
What others say
Ward is not the only person who has highlighted this alternative approach. Financial advisors Melissa Joy, director of wealth management at the Center for Financial Planning, and Randall Greene, CEO of Greene Financial Management, both agree there are situations in which it makes sense not to solely focus on repaying debt.
A personal choice
At the end of the day, deciding which approach to take is a very personal choice. The best approach for an individual will vary according to the amount of debt they have, the interest being charged on it, whether they have any savings to fall back on and if they are disciplined enough to stick to the approach they choose. Whichever route you take, it is important to budget, live within your means and try not to get into debt in the first place.