Paying Down Debt vs Saving and Investing

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The question of whether to focus on paying down debt or to prioritise saving and investing is one that many people wrestle with. Like most trade-offs there are several variables to consider, so let’s see if we can simplify this into some workable strategies.

Firstly, you cannot come to a conclusion unless you have a handle on your budget. Getting clear on your income and expenditure is the first step. That way you will know exactly how much you have left at the end of the month to allocate.

The next thing is to make sure you have some basic financial security. If you don’t have any savings it is perhaps prudent to pay off the minimum on your debt until you can build up an emergency cash reserve. Aim for a minimum of three months expenses so you have some breathing space if you lose your current source of income.

Obviously you want to try to pay off any high interest debt first. Credit cards are the number one offender here. With APR often as high as 18% it is wise to clear this as quickly as possible.

Student loans often come next. For people who studied in the US for example, student loan interest rates seem to be around 6-7%. If you are thinking of investing the money to get a better return and pay off the debt later, this is not an easy hurdle to clear without taking a lot of risk.

Where the trade-off question gets interesting is with home loans, particularly for people living in Japan with floating interest rates below 1%. There’s a strong argument for making your minimum monthly payments and saving and investing everything you can. I certainly wouldn’t disagree with that, but everyone feels differently about debt. I know people who never bought their own home because they couldn’t stand the idea of owing the bank that much money. If it keeps you awake at night, there’s nothing wrong with paying off your mortgage as fast as you can.

Once again, it’s good to make sure you are clear on your budget. Then make sure you have an emergency cash reserve, and have protected yourself in case you get sick or injured and are unable to work. In Japan you are required to buy life insurance to cover the loan in case of death, but in other countries you may need to consider this yourself. Paying into some kind of pension plan counts as one of the basics too and I would prioritise that over paying down debt. In his book Rich Dad Poor Dad: What The Rich Teach Their Kids About Money That the Poor and Middle Class Do Not!, Robert Kiyosaki talks about the concept of paying yourself first – make sure you are saving and investing for your future before paying the bank back more than you have to.

That said, if you are hitting your targets for saving and investing, then paying down debt is certainly not a bad thing. It reduces the amount of interest you will need to pay over time and the number of years it will take to repay the loan. Even 1% per year adds up!

For people in Japan, here’s an unexpected bonus: In order to get a mortgage in Japan you are required to appoint a guarantor. For expats this usually means paying a loan guarantor company, and you pay them up front when the loan is arranged. If you make ad-hoc lump sum payments to reduce the debt, the guarantor’s liability is reduced and they actually pay you back some of their guarantor fee. We recently made a payment of ¥1,000,000 on our home loan and received almost ¥60,000 back from the guarantor.

So to summarise, cover the basics first, prioritise high interest debt, and make sure you are saving and investing for the future whilst paying off the rest.

 

 

 

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