Why you shouldn’t rush to pay off your debts

Reducing your debt levels may not be the most logical use of your cash.

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

Public domain.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

For many people, being in debt is a part of life. Paying for a car or a house often requires borrowing. As long as the amount borrowed is sensible compared to your income, the cost of servicing the debt remains affordable and financial difficulties do not arise.

However, paying off debts is a central goal in many people’s lives. The idea of owing others can be an uncomfortable situation, even if the repayments are affordable. Therefore, when interest rates are higher than the income return from assets such as shares and bonds, the logical thing to do is to pay off debts as quickly as possible.

That is not the situation at the present time. It is possible in countries across the globe to borrow at a lower rate than the income return on national stock markets. For example, in the US the S&P 500 yields 2.2% at the present time and interest rates are just 0.5%. Similarly, in the UK interest rates are 0.25% and the FTSE 100 yields 3.7%. Therefore, it is possible to borrow at a low rate and generate a higher income return from investing in a diversified range of companies.

Clearly, this idea is not without risk. Interest rates in the US are forecast to rise over the medium term and this could cause the profit generated from investing borrowed money to be reduced. However, the Federal Reserve continues to adopt a dovish stance which means that there is just one rate rise forecast for the next year. In fact, US interest rates are expected to be 2.25% in 2020, which is still relatively low and only 5 basis points higher than the S&P 500’s yield.

Another risk from investing borrowed money is that the value of the asset purchased can fall. A 2.2% income return on the S&P 500, for example, would be of scant consolation if the index dropped by 10% or more. And if a recession hit and caused uncertainty regarding employment, an investor’s ability to repay debts could come under pressure.

However, the idea of investing borrowed money still has merit. What it could mean in practice is that instead of rushing to pay off debts as quickly as possible, an individual maintains a level of debt over the medium term which remains very affordable and within their financial means. This money could be used to invest in a diversified portfolio of shares in order to generate higher returns for the investor.

While this will increase the overall risk profile of a portfolio, the potential rewards would also be boosted. The end result may be a superior risk/reward ratio which means that a debt free life may not be the most efficient use of capital at the present time.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

More on Investing Articles

Investing Articles

Could the JD Sports Fashion share price double in the next five years?

The JD Sports Fashion share price has nearly halved in the past five years. Our writer thinks a proven business…

Read more »

Bus waiting in front of the London Stock Exchange on a sunny day.
Investing Articles

If interest rate cuts are coming, I think these UK growth stocks could soar!

Falling interest could be great news for UK growth stocks, especially those that have been under the cosh recently. Paul…

Read more »

Investing Articles

Are these the best stocks to buy on the FTSE right now?

With the UK stock market on the way to hitting new highs, this Fool is considering which are the best…

Read more »

Petrochemical engineer working at night with digital tablet inside oil and gas refinery plant
Investing Articles

Can the Centrica dividend keep on growing?

Christopher Ruane considers some positive factors that might see continued growth in the Centrica dividend -- as well as some…

Read more »

Smiling family of four enjoying breakfast at sunrise while camping
Investing Articles

How I’d turn my £12,000 of savings into passive income of £1,275 a month

This Fool is considering a strategy that he believes can help him achieve a stable passive income stream with a…

Read more »

Person holding magnifying glass over important document, reading the small print
Investing Articles

2 top FTSE 250 investment trusts trading at attractive discounts!

This pair of discounted FTSE 250 trusts appear to be on sale right now. Here's why I'd scoop up their…

Read more »

Smiling young man sitting in cafe and checking messages, with his laptop in front of him.
Investing Articles

3 things that could push the Lloyds share price to 60p and beyond

The Lloyds share price has broken through 50p. Next step 60p? And then what? Here are some thoughts on what…

Read more »

Young female business analyst looking at a graph chart while working from home
Investing Articles

£1,000 in Rolls-Royce shares a year ago would be worth this much now

Rolls-Royce shares have posted one of the best stock market gains of the past 12 months. But what might the…

Read more »