FOOL'S EYE VIEW
Get Out Of Debt

By Alan Oscroft
January 11, 2001

Liverpool -- If you ask a sample of private investors what the biggest investment mistake you can make is, you can be sure of getting a whole load of different answers. Many will say it's paying too high a price for shares, some will say it's allowing emotion to rule over logic. Some people will even say it's not getting your timing right, or perhaps even not using a stop loss strategy (yes, even stranger things have been claimed).

The title of this piece probably gives away what my answer would be. Borrowing money to invest is probably the biggest mistake you can make. If you think about it, investing money in shares while at the same time carrying debt is effectively the same thing (because using your cash to buy shares and your credit card to buy a television is no different to buying the telly with cash and the shares with credit). And that's why January at the Fool has been designated "Get Out Of Debt" month.

Mortgages are one exception, and at the Fool we generally think that they constitute the only Foolish kind of debt there is, because the interest rate is relatively very low. So, you needn't wait until you're old and grey and the mortgage is paid off before you think about investing in shares, but there are some things you should definitely pay off first. Debt comes in many forms, but today I just want to cover the two that I think are the most dangerous (because they're expensive and convenient -- a deadly combination).

Credit Cards

What's the interest rate on credit cards? Despite all the low introductory offers around (just a few per cent on balance transfers for the first six months, or whatever), the average rate is still firmly in double figures, with some even exceeding  20% per year.

If you invest in shares while carrying credit card interest at, say, 17% per year, you'll need to see your shares appreciate by more than 17% per year to make it worthwhile. The stock market has increased, on average, by 12.2% per year since 1918, and many observers today expect the next few years' returns to be less than that, so you're going to need pretty impressive market-beating returns just to break even.

Even if you believe you can consistently beat the credit card rate, you'll be taking a high risk while chasing the kind of net return that is normally consistent with a low risk investment. Suppose, while paying credit card interest of 17%, you actually manage to get a 23% return on your shares, giving a net return of 6%. Now, that's the kind of return you can expect from a savings account. But savings accounts carry virtually no risk, while shares carry significant risk. Long term, the risk will get you, and there are very few people out there who will be able to get that 23% per year consistently.

Store Credit

Need a new suite but don't have the cash? Do you have any shares? You do! Well then, if you really need a new suite then perhaps you should sell a few and buy one. What's that? You don't want to sell your shares because they're part of your retirement plan? A noble aim, but you can't keep them all and still have that suite. Or can you?

Most furniture shops offer credit terms and thousands of people every year are tempted. But credit is just another word for debt, used simply to make it sound more palatable. Check the small print to see just what the interest rate is. The chances are that it will be similar to credit card rates. Buying that suite on credit will eat up your investment returns and then some.

"Ah, but Suites'R'Us are offering 3 years interest-free credit," you might reply, and that's surely got to be a good deal. But wait a bit and think about it. The credit for such deals is supplied by a third party finance company (read "someone else is lending you the money"), and they're not doing it out of the goodness of their hearts. No, the credit company is taking a handsome rate of interest and the money to pay it is included in the price of those comfy chairs that you like so much. Don't believe it? Try offering cash and see if they'll lower the price. Some stores won't lower the price for cash, because that would show up just how much their "interest free credit" is really costing you. If that happens, try comparing prices with other stores that state their financing charges more clearly and which sell their goods cheaper for cash.

If you really, really do need a new suite and you have no cash because all your savings are in shares, then what you've been doing is investing too much. You've been buying shares with the cash that should go on necessities (and something to sit on is a necessity), and buying that suite using debt is not the way to do it -- it's the same as borrowing money to invest.

The Motley Fool's Get Out Of Debt Centre

Many people have high debts and no investments at all, of course, and that brings me on to the Fool's latest offering. We'll be launching our new "Get Out Of Debt" centre very shortly, and it will cover everything you need to know to get your debts under control -- How to track your monthly income and outgoings properly (if you can't even tell how much money you have spare, you can't hope to control it), how to avoid debt in the first place, how to plan to get rid of your debts of you do have any. And for people who have got themselves so far into debt that they can't keep up the payments, there are people out there who really will be able to help, and the Get Out Of Debt centre will direct you to the resources you'll need. Keep your eyes peeled.

Where Next?

• Dealing with Debt discussion board