Is it best to pay off your credit card straight away? Or do you make more money by investing in a high-interest account or shares?
When it comes to simple savings strategies, this should be one of the first questions you ask. And thankfully, we’ve got all the numbers to help you decide.
Credit Card Crunch
Here are some scary statistics: there are well over 16 million credit cards in Australia, with a total national credit card debt of $33 billion. The average credit card balance is $3,181.
A credit card start to cause problems for people when its balance goes past the interest-free period and starts accruing interest.
That’s because the typical interest rate on credit cards in Australia is 14%!
When we talk about “investing” we can be talking about a lot of things. For our purposes we’ll keep it simple: “Investing” is about saving some money and putting it someplace where it will grow into more money in the future.
Let’s look at the 2 most common options for investing (no, putting it under the mattress isn’t one of them).
1. Savings Accounts
If you put your cash in a regular transaction account, you can expect the interest rate to be pretty close to zero. So, you’ll need to look elsewhere.
For example, in a term deposit, you can get around 3% per annum (per year). In simple terms, that means if you put $3,000 (say the entire credit card balance from above) in a one-year term deposit, at the end of that year it will be worth about $3090.
The historical return of the total Australian share market has historically been around 8% per annum. That means that if you were to invest your $3,000 in shares today, you could expect the value of those shares to rise on average to around $3,240 by year end. However, the share market is unpredictable. There have been years when the market went up 15% or 19%, and years when it went up by only 3%, 1% or even went backwards, so it’s no sure thing.
A Fire or a Growing Pot Plant?
Debt is like a fire. Left on its own, debt grows and consumes more and more. Why? Because of those 14% interest rates we talked about earlier. Look at it this way: $3,000 of credit card debt (which remember, is about average) at 14% interest will grow to $3,420 of debt in just one year! And, it only gets worse from there.
Investing is more like a pot plant. It also grows, but much more slowly. Going back to the rates we used before: cash grows at about 3% and shares will grow at around 8%, turning $3,000 into $3,090 or $3,240.
Now look at your two options and consider them side-by-side. Do you put out the fire first, or water the pot plant? The “water” you have to put out the fire or nurture the pot plant is your money.
It’s an Obvious Choice
You put out the fire. Why? Because if you don’t, the fire will keep growing, and causing damage. In our example above by “investing” your money instead of paying down your credit card debts (putting out the fire) you’d end up at least 6% worse off over the course of just one year.
It all comes down to the interest rate differences. Because of the massive interest rates charged on credit cards compared to your investment options, your debt will almost always grow faster than your investments can.
A Bucket of Money
Here’s another way to look at it. Consider that your money is water in a bucket. Say that bucket holds 10 litres of water. If you have credit card debt, your bucket will “leak” 14%, or 1.4 litres per year. If you have investments you can “refill” your bucket with, at most, 8% of the water it can hold, or 0.8 litres of water per year.
No matter what you do, the bucket will always “leak” faster than you can “refill” it.
So do you pay off your credit card or invest?
It’s a matter of timing.
So, when it comes to figuring out whether you should invest or pay off your credit card debt, of course you should do both. But the order matters. Put the fire out first by paying off your credit card. Then grow your pot plant for the future by investing your money.