If you are juggling debt repayments while saving for retirement, you might be conflicted as to how to allocate your money and where to put it first.
Whether you should save, pay off outstanding debt, or even invest first is a personal decision and depends very much on your unique financial situation and goals.
Before any of us can start working off our debt or building our wealth, we need to understand which financial scenario we should prioritise for ourselves. Here are 5 things you need to consider to decide what suits you the best.
Set up an emergency fund
Even before you look into reducing your debt, it's prudent to at least have an emergency fund in place.
The most expensive mistake you can make is to not budget for unforeseen circumstances and large expenses such as job loss or major illnesses. If you don't already have an emergency fund, it is important to prioritise setting aside some cash.
A general guideline is to have enough money in your emergency fund to cover at least three to six months' worth of expenses. That being said, this is not a hard and fast rule.
Consider these factors to get a clearer picture of how much you need to save:
- Your job security and employee benefits: A freelancer or self-employed person might need a larger emergency fund than a salaried employee, if their income is not always consistent or stable and if there is a greater risk of job loss. Additionally, consider what benefits your company offers, such as medical and dental insurance coverage.
- Your dependants and their needs: If you have a big family, with more children or ageing parents, your emergency fund will need to be large enough to provide for everyone in the household in the event of unforeseen expenses.
- Your risk appetite: How much and what kind of risks are you prepared to handle?
To add to your emergency fund passively, consider "paying yourself first", by squirrelling away a fixed sum every month into a low-risk cash management product — this may be a money market fund or a high-interest savings account. Your cash management strategy is another essential part of your financial plan.
For a more detailed guide on how to build and manage an emergency fund, click here. Also, pick up some tips on how to save more money.
Avoid taking on more bad debt
As Hong Kongers, most of us were taught from a young age that all debt is bad. But the truth is more complicated.
Differentiating between good and bad debt can prevent you from taking on an unnecessary financial burden, and help you create an effective debt repayment plan.
Good debt vs bad debt
What is good debt? Essentially, it is incurred from expenses that will help you grow your human and financial capital, and has the potential to improve your overall financial health. Good debt typically has low interest rates, can help you generate income in the future, and may increase your net worth. University student loans and some mortgages may be included in this category.
In contrast, bad debt is incurred from expenses that will not help you generate income and does not contribute to your financial health. It is often a sunk cost and carries relatively high interest rates. Credit card debt and car loans are examples.
The main goal is to limit unnecessary expenses that can lead to bad debt, and to always spend within your means. This can mean avoiding luxury purchases such as extravagant holidays or costly designer watches.
Evaluate all your outstanding loans
Know what debt you owe. List out all your loans, including the interest rates, how much is outstanding, and payment due dates.
This will allow you to then think about how best to repay them, and over what duration. The following table is an example of how to organise your debt information.
Begin to budget towards your monthly debt repayment plan just as you would with utilities and food. Debt expenses should be treated like any other expenses.
After that, allocate some of the leftover funds each month to other financial objectives such as investing or saving. If you don't have any money left over after debt repayments, your budget might be unrealistic and should be reworked.
Create and stick to a debt repayment plan
Some debt arrangements can roll on indefinitely, while others have a monthly repayment schedule. Identify this for each of your loans, and work them into your repayment plan so that you avoid incurring huge interest expenses from missed payments.
To get out of debt fast, one way is to restructure your debts by paying off loans with very high interest — such as most credit card debt (usually with about 35% interest per year in Hong Kong) — by taking out a personal loan with lower interest rates (some may go down to around 5% to 7% interest per year). This debt consolidation strategy allows you to save on the interest rate difference of around 20%, especially if your loan quantum is high.
Another method of approaching your debt repayment plan and steering away from further debt accrual is to organise your loans by interest rates. This is known as the "avalanche debt" method — you start by paying off the debt with the highest interest rates first.
Paying down debt with the avalanche method:
Another approach is the "snowball method". This strategy involves prioritising your debt by the dollar amount of the outstanding balance, and start by paying off the lowest amounts. Although you might not save more on interest with this method, it is more encouraging and has been shown to have more psychological appeal when it comes to building long-term financial habits.
Paying down debt with the snowball method:
Make a call: Invest with debt outstanding, or repay all debt
We glorify the idea that being debt-free is the only key to a successful financial life.
But paying off all your debt quickly does not always make sense for everyone.
For example, if you have a long-term mortgage with an interest rate of 1.4%, but you expect an investment return of 7% to 10% from the stock market each year, you can make your money work harder by investing any spare cash instead of using it to pay off the home loan.
While this can be seen as indirectly leveraging on your investment, the risks have to be assessed carefully on a case-by-case basis:
- Match the timeframe between the debt and the investment. You should not make a long-term investment with high volatility, with money meant to pay down a debt that is due soon. This is also known as asset liability matching.
- Ensure that you are getting higher returns from your investment than the cost of debt. For example, you would not want to take up a personal loan at a 10% interest rate to invest in a money market fund that yields less than 1%.
- Consider any early loan repayment penalty. The interest saved from paying off a loan early could be less than the repayment penalty paid.
Managing your debt well can help you enhance your life and achieve your financial goals.
As writer and entrepreneur Grant Cardone once said, "Rich people use debt to leverage investments and grow cash flows. Poor people use debt to buy things that make rich people richer."
Ultimately, debt is a double-edged sword that can work for or against us. Being deliberate and measured with our debt decisions can allow us to use debt effectively for our financial goals.
Once you have built an emergency fund and are comfortable with your debt management strategy, consider taking the first step of your investment journey. The Endowus Global model portfolios are where you can begin, and allow your returns to compound over time. To get started with Endowus HK, click here.
You may also wish to plan and save for retirement early, so as to avoid being financially insecure and having to work in old age. Refer to this simple checklist to prepare for your golden years.
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