FOOL'S EYE VIEW
A Bird in the Hand...

By Jane Mack (TMFJane)
August 7, 2001

I was having a play with a fun little tool the other day that claimed to evaluate my Money Personality. Apparently I am "balanced" -- not something those who know me would necessarily agree with, naturally -- but nevertheless I felt rather pleased with the result, even if it did only relate to financial matters!

I have a right to be pleased actually because, before I became a Fool, the scales were tipped rather heavily in a negative direction -- and now they're not. I learned pretty quickly that it makes sense to pay off debts first. There's simply no point in paying vast amounts of interest on money that you owe if you're reaping much smaller returns on the money that you're saving.

But it's still a big temptation to try and start saving and investing for the future even when you've got a bundle of debts to clear. And I have to admit that, in my new-found enthusiasm for investing in the stock market, I made a few mistakes. Luckily it didn't involve much money -- but it's sometimes difficult to know where to start when you've got an unbalanced set of scales in the first place.

One of our Fools is currently facing a balancing problem in that he has £11,000 at his disposal but also has £11,000 of debt.

As we all know, the sooner you start investing the sooner the miraculous effects of compound interest will kick in, so our Fool is worried that if he uses his money to pay off the debt, he'll be missing out on the potential returns of the stock market.  He was wondering whether to invest his lump sum now whilst continuing to pay off the debt separately over the next five years.  

Since the interest rate on his debt is about 8% and we know that, historically, the stock market has averaged returns of 8% (if you take into account inflation), you might think it doesn't matter which route he takes since, in theory, he'll end up with exactly the same amount of money either way in five years time.

Not so, of course. For one thing, paying off the debt automatically gives him a guaranteed return of 8%. He has no debt -- therefore, he has no 8% to pay. He has immediately saved 8%. Now, that's a pretty good return on his investment.

The second point is that, while the stock market may have averaged returns of 8%, there is no guarantee that it will continue to do so. It has fluctuated wildly recently and our Fool would, no doubt, be far from happy if his £11,000 investment promptly dropped by a few thousand because he'd put his money into the market just at the wrong moment. Not to mention the fact that he'd still have his debt to pay off. It's true that if he times it well then he could be laughing all the way to the bank but there's simply no guarantee that good fortune will smile on him at this particular moment. Is it really a risk worth taking?

What he could do is pay off the entire debt now, saving himself 8% in interest payments, and then put the monthly payments he would have put towards the debt into the stock market. That way he's still started saving for his future and he doesn't have to worry about timing the market because he'll be drip-feeding his money into the pot. By taking this course of action he wins when he's buying in at low prices but doesn't lose vast amounts if he finds himself inadvertently buying at high prices. He also doesn't have any debts to worry about.

Of course, he knew all this when he asked the question in the first place but there's no harm in talking it through just to make sure. If you've got the opportunity to get shot of your debts, then that's almost always the route to take. As one Fool put it, a bird in the hand is worth two in the bush.

More: the Fool's Get Out Of Debt Centre