Road to FIRE #2: But what about debt?

Pulling out the plastic is just so easy… (credit)

I want to take a small detour before we dive into what to do with your potential savings. We need to discuss debt – what it is, what it isn’t and why it can be okay in certain instances and horrific in others. I am generally of the belief that debt aside from a mortgage (a loan against the property you live in), at least in the UK, should be avoided and that is only because the UK has a strange obsession with house prices which has led to some very odd incentives for house ownership. But I digress…

What is debt?

Debt is, in simple terms, when you owe someone else something in exchange for a service or good. Financially, this is when you are borrowing money from a person or company and use it to buy something – be that a car, a house, a big screen TV or even groceries. In exchange for lending you this money, most lenders want an additional portion of money back on top of this, called interest. The higher the percentage of interest the lender charges for their lent money, the more money you will have to pay back over a set period of time.

If you borrow £1,000 at 25% interest over 1 year, you will end up paying roughly £1,250 back to the lender. It cost you £250 to borrow that £1,000. I imagine you would much rather keep that money for yourself! Incidentally, the current average credit card interest rate is nearly 25%. If you are currently able to save £100 a month but borrowed that £1,000, then it is going to take you longer to pay off the loan than if you had saved for it in the first place! You could argue that your impatience cost you £250. Or you received the item / service 10 months earlier than if you’d saved, but the express delivery option just cost you £250.

Good debt, bad debt

“But I had to pay the £1,000 then, my car broke down and needed fixing!”

Protesting reader

I agree, in that case you had other option to get to work. However, why didn’t you have some emergency money ready just in case? And this cycles us back to the wider problem in the UK right now – people aren’t saving and are getting into debt. And debt is generally expensive to have. It saps your already limited resources and makes it even harder to save.

So step #1 needs to be – no debt (excluding mortgages) in your life.

If you are already at this point, then congratulations, but I think the “good debts” and “bad debts” needs further explanation. A “good debt” is a debt that either provides a vital service or asset that increases in value over time, such as, traditionally, a property you live in or an education (and frankly even the university education argument might have changed since I went).

A “bad debt” is buying something that either loses value over time or has no real value to start with. Typical examples being a new car, expensive clothes, new toys, an exotic holiday, etc. By all means, if they are that important to you, save up and buy them – but DO. NOT. BORROW. TO. BUY. THEM! The temptation to have what you want right now is always hard to resist, but trust me, you will end up paying far more than you ever wanted to for something that will generally lose its appeal surprisingly quickly.

A whole lot of saving required to get here (credit)

An aside to those with no way out

A quick note before we begin – if you are truly incapable of dealing with your debts and need professional help, there are debt charities and services out there that can help you in the UK. I am writing my blog on the assumption you have some disposable income available. If this is not the case, get in contact with the services below to help right your ship before you truly sink.

Killing your debt ASAP

For the rest of us, draw up a list of all your debts, the amounts owed and the percentage interest rate charged on each debt. You may end up with something like the below fictional example:

  • Credit Card #1 – £5,000 – 25% interest
  • Credit Card #2 – £2,000 – 20% interest
  • Car Loan – £10,000 – 10% interest

This person is paying around £2,650 a year to service this £17,000 debt! Holy shit!

The correct mathematical way to attack these debts is to push all available funds towards the highest interest debt first, then the next highest, then the next highest until all your debts have been paid off. In this case, we would attack the 25% interest debt first, even though the 20% interest debt is smaller and could be paid off sooner.

Returning to our example of our mystery median UK earner from the last post who was earning £19,556 post tax and had basic needs outgoings of £15,000 a year, let’s slap on the £2,650 of debt interest they are paying to service the above debts. From their initial leftover ‘perfect saving’ amount of £4,556 they are down to £1,906 a year to save. Seeing as savings rates have been pretty low for the past decade, it would instead make more sense to pay down the debt ASAP.

Visualising the debt crushing

I plugged the above data into a spreadsheet and calculated roughly how long it would take to pay off the above debt with the resources of our mystery median UK earner. The results were pretty shocking:

First credit card paid off at A (35 months), second credit card at B (43 months) and loan paid off at C (79 months)
(Click to enlarge)

Take a look at that time period. Nearly 80 stupid months or nearly goddamn 7 years to pay off! Over £8,000 in interest to the lenders (red line)! And this is assuming that no further debt is acquired in those 7 years and that all available money, including freed up money from not having to pay the other debts as time goes on, is chucked at this thing.

And the worst part? If they had simply saved their £4,500 a year from the beginning and never taken out the £17,000 in loans, they would have £17,000 in just under 4 years! Instead they paid £25,000 for £17,000 of money. You can see why I am very against debt. It is a massive drain on your life, your mental health and your own well being.

So, people of the UK – I propose to you a very simple message to repeat to everyone:

I do not borrow money for anything but a property or an education. Everything else I will save up for before I purchase it.

Enlightened Reader

And with that out the way, let’s get into what to do with your newfound savings habit!

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