With the rising cost of university, graduating with large debts is an unfortunate reality for most doctors. The modern world also foists debt on us at every opportunity. We are constantly bombarded with ‘buy now, pay later’ offers and it's become normalised to pay hundreds of pounds a month to drive a brand-new car that you’ll never own. But not all debt is equal and some debts can enhance your wealth, while bad debt can destroy your wealth. Being able to distinguish good debt from bad debt has never been more important and is key to building a secure financial future.
Good debt vs bad debt
Good debt is generally low interest rate debt that is used to buy assets that appreciate in value. The classic example of this is taking out a mortgage, which is low interest rate debt, that is used to buy an asset that has historically increased in value. Of course, interest rates have increased over the past year and some people are finding that their mortgage repayments are going up, perhaps significantly, but the general principle remains that mortgages as classified as ‘good debt’.
Bad debt is high interest rate debt that is used to buy assets that depreciate in value. A store card with a high interest rate that is used to buy clothes that depreciate in value is an example of bad debt. Car loans can also be examples of bad debt. You can tell just how bad an investment most cars are by the fact that HMRC considers most cars a ‘wasting asset’ and exempts them from capital gains tax to stop taxpayers from claiming a capital loss when they sell their cars.
Repaying debt
It won’t be a surprise to you that the recommendation is for bad debt to be repaid as fast as possible. It will be dragging down your net worth and needs to be a top priority. There is no one definitive way of repaying bad debts however and there are different approaches to doing so.
The one that is more widely used has a very catchy name: the ‘mathematically logical method of debt repayment’. Under this approach, the recommendation is that you write down all the debts you have with the amounts owed and the respective interest rates. First of all, it is recommended that you pay the minimum monthly repayment required to avoid any additional costs or penalties on all debts. Next, start repaying the debt with the highest interest rate first. By doing this you pay off the most expensive debt first and then once that is paid off you move to the second most expensive debt and so on. So, if you have credit card debt with an APR of 19%, an overdraft with an interest rate of 3% and a bank loan costing you 5% interest you would start by paying off the credit card debt first, then the bank loan then the overdraft.
There are other approaches of course. Another theory is that by paying off the smallest debt first and working upwards you will experience a positive psychological effect that will snowball and make it easier to repay your debts.
Should I repay debt or invest?
This is a common and important question but basically it all comes down to the mathematics. If you do invest the money, will you make more from the investment than you will pay in debt interest? If your credit card bill is accumulating interest at 19% per annum it is unlikely that you will be able to invest in such a way that you will achieve an investment return exceeding 19%. In this case you will be better off repaying the credit card debt. Be realistic regarding investment rates of return as well – if you were to find an investment that says it offers a 20% rate then this would be better than paying off credit card debt with a 19% interest rate… but exercise a lot of scepticism if you come across a rate this high, research it thoroughly, appreciate the risks and make sure you are aware of any costs that will bring the return down.
Note that paying off bad debt will increase your net worth and is effectively a ‘guaranteed rate of return’. You would be hard pressed to find an investment with a guaranteed rate of return of 9%, say (and most investments can go down as well as up), but paying off debt with an interest rate of 9% is a guaranteed way to increase your net wealth.
Other points to consider
Remember that some debts may have early repayment charges if you do want to repay them early and these can be punitive. Make sure you are aware of any charges that will arise if you want to repay debt that you hold.
While we have talked about repaying off bad debts, you can also pay off good debts – an example would be overpaying a mortgage. Again, consider whether you will be better off repaying these versus investing the money instead and check if there are any early repayment charges. Some people are currently on fixed mortgage interest rate deals and trying to overpay their mortgage before they must re-mortgage at a higher interest rate.
Some debt can come with tax advantages such as the loans taken out by GP Partners to buy their own surgeries.
Summary
It is important to consider the difference between good and bad debts and repay your bad debts as soon as possible to grow your net worth. Start by paying off the minimum monthly repayment required on all your debts to avoid any additional costs or penalties then start paying off the debt with the highest interest rate first. On the whole it is usually better to repay bad debt before investing. By repaying off high interest bad debts you will be growing your net worth and putting your finances on a more secure footing.