Step 4: Dump Your Debts

Unfortunately, we Brits have become a lot more comfortable with living with debt in the last couple of decades. The trouble is that, while the miracle of compound returns can be a fantastic thing when you’re saving or investing, it works in reverse when you’re borrowing, which explains why debt can often spiral out of control.

So before you build up an emergency fund or look to invest and grow your wealth, you should make sure you have paid off as much non-mortgage debt as possible. If you don’t, it’s very likely that you will be paying a lot more in debt interest than you could ever hope to make from any savings or investments.

Prioritise your debts

In Step 2 we looked at how you can draw up a budget to analyse your income and expenditure. This should help you identify areas where you can save money or cut back on, which will free up more cash to pay off your debts.

You should also draw up a list of all your outstanding debts, with details of how much you still owe, how much you pay each month, and what the interest rate you’re charged is. This gives you an idea which debts to prioritise. You should always make sure you can meet any minimum monthly payments, but after that it will generally make sense to pay off the debt that charges the highest interest rate first. Once that is cleared, move on to the next highest and continue the process until everything has been paid off.

Dealing with large debts

The Fool’s debt discussion board is a great free resource to help you get a handle on your debts, combining advice on what to do and inspiring stories from people that successfully paid off all that they owe. But the most important thing in this situation is not to panic. You probably have a lot more options than you realise, and there are various laws and regulations in place to protect you.

For example, you might be able to reduce the cost of some your debt by switching to a low-cost loan or credit card. Taking out more debt can be a dangerous route if you don’t actually start paying off what you owe, but cheaper debts might give you valuable breathing room.

In extreme debt situations, where you can’t see a way of paying off what you owe, you may need to contact your creditors to arrange an affordable repayment plan. There are a number of free debt charities that can assist you in this process, but we would generally suggest avoiding companies which charge for this.

In some cases, you find bankruptcy may even be your best option. Again we would say “Don’t panic!” Many people have been down this road and got their finances back on track as a result.

Should you pay off your mortgage before you invest?

There is no simple answer to this question, so it often comes down to personal preference.

Paying extra off your mortgage can save you a lot of interest in the long term, and there are various free calculators across the Internet which can run the numbers for you.

However, not all mortgages are that flexible, so make sure you don’t get penalised for making early repayments. In many cases, once you have paid off a chunk of the mortgage, you may not be able to get that money back if you need, should your circumstances change. So some people take a balanced approach, using some of their spare cash to pay off their mortgage and the rest to invest.

Next we look at mortgages and homeowning in a little more detail.