Should you use your spare money to invest or should you use it to pay down your debt? With borrowing costs going up, it’s a dilemma many people are increasingly thinking about.

It’s tempting, for starters, to compare the interest rate you pay on your debt with the return you hope to achieve with your investments and to conclude that redirecting more of your hard-earned money to whichever is highest might not be a bad idea.

After all, as we always advocate at Vanguard, paying off high-interest debt such as your credit cards should always come before investing.

Trouble is, you also have personal goals and an ongoing need for some financial flexibility. And the more disposable income you assign to pay down debt, the less money you will have to fund those longer-term life goals.

In addition, not all debt is the same, while some investing carries tax benefits.

If the broad objective is to maximise your long-term net worth – your assets minus your debts – you need to manage both sides of the balance sheet as cannily as you can.

To help you weigh up the trade-offs, here’s a framework. It has three essential components:

• Understand your debt.
• Understand your investment options.
• Balance your different goals.

Understand your debt

The most debt many of us will ever incur is through the mortgages on our homes, although for younger investors¹ it’s probably student debt that looms largest.

Each type of debt has its own characteristics and some versions are more flexible than others.

Some mortgages, for example, allow overpayments. Others limit them. Beware early redemption charges on fixed-rate deals too.

Student debt, meanwhile, doesn’t start to be repaid until students earn above a certain threshold. Even then, you pay a fixed percentage² of the amount above this threshold, much like a tax. The debt in some situations can be written off eventually³. 

Whether or not it makes sense to prioritise debt repayments over investing, these debt differences need to be considered.

Understand your investment options

The government offers tax incentives to encourage everyone to save and invest. But the potential tax benefits differ, depending on the type of investment account chosen and the degree of flexibility required.

In the case of individual savings accounts (ISAs), you can invest up to £20,000 a year⁴ and not pay tax on the returns or capital growth your investments may subsequently experience – this includes capital gains tax (CGT) as well as income tax.

You don’t even have to provide details of your ISA investments on your annual tax return. Just remember that all investing involves risk and that the value of your investment can fall as well as rise.

An ISA also gives you flexibility: you can withdraw your money at any time to fund any short-to-medium-term objectives you may have – whether that’s saving for a house deposit or a wedding⁵.

There’s less flexibility when it comes to investing through a pension, including a self-invested personal pension (SIPP). Once money is deposited in a pension, you can’t access it until you’re at least 55 (rising to 57 in 2028).

However, what you get with a SIPP that you don’t get with an ISA is tax-relief on your contributions⁶. Simply put, for every £80 of income paid in, basic-rate taxpayers get a £20 top-up automatically. And if you’re a higher-rate or additional-rate taxpayer you may be able to claim back even more through your annual tax return³.

When it comes to your workplace pension, it’s also important to remember that some of your contributions may be matched by your employer, which is effectively free money.

Balance your different goals

Long-term goals such as a well-funded retirement may compete with shorter-term goals such as saving for a house deposit or being adequately prepared for a financial emergency. To resolve this conflict investors can, if they want, take the following steps:

• Prioritise higher-return opportunities.

Some investment opportunities may be too good to pass up, like the employer-matching you may get on your workplace pension or the extra tax relief you might get on pension contributions.

Similarly, we believe you should always pay down high interest-rate debts such as credit cards, which can spiral out of control if left untended.

• Make sure to have adequate emergency savings to meet potential financial shocks.

Without stable savings, you could be forced to take on additional debt under unfavourable conditions and at inopportune times. It helps to have a cash buffer.

• Prioritise your remaining goals and determine the most appropriate savings vehicles.

If your goals are five years or fewer away, say, then making sure you can freely access your money when needed might be more important than if the opposite was true.

Weighing the trade-offs

The right balance may also depend on your personality and priorities. How cautious or thrifty are you naturally? Do you have major spending goals on the horizon? What would you do with the extra cash flow if your outgoings were reduced? How much do you value having access to readily available funds?

When deciding between the prepayment of debt and investing, the answer will ultimately depend on your goals and circumstances.

 

¹ In 2020, 59% of households headed by someone aged 25-34 did not own their home, up from 41% less than 20 years earlier. Source: Extending home ownership: Government initiatives, 30 March, 2021.

² 9% for most graduates.

³ After 40 years under new government proposals, from 30 years currently.

⁴ Or £9,000 in the case of an Junior ISA.

⁵ In the case of a Vanguard stocks and shares ISA, you can also take money out and then put it back in again later in the same tax year without it affecting your annual ISA allowance. Not all ISAs are as flexible.

⁶ Subject to an annual cap of £40,000 (or 100% of your annual gross earnings, if lower than £40,000), comprising the sum of your personal contributions, employer contributions and any government tax relief received.