Prioritising debt reduction

Most of us carry some form of debt. It is not necessarily a bad thing however, prioritising debt reduction should be part of your financial plan. As a financial planning firm, debt management is one of the most important conversations we have with clients. For many, the focus is often on growing their wealth through investments, property, or retirement savings. However, the impact of personal and household debt on these long-term goals is often overlooked.

Debt reduction should be a top priority, as managing and minimising debt can significantly increase the number of discretionary funds available for future investments, securing a more comfortable retirement.

The convenience of credit cards and personal loans can lead to a false sense of financial security, where the ease of access to borrowed money overshadows its long-term costs. Many individuals fall into the trap of making only the monthly minimum payments, believing this approach is enough to keep their debt under control. However, this strategy often backfires because of the way interest charges work. When you make only the minimum payment, a large portion goes towards paying interest rather than reducing the principal amount owed. As a result, the outstanding balance barely decreases, and the interest accumulates monthly.

Consider a credit card debt of $10,000 with an interest rate of 20%. The debt does not reduce significantly if only the minimum payment is made each month—typically around 2% to 3% of the outstanding balance. In fact, by making only these minimum payments, the debt could easily balloon to over $12,000 within a year due to compounding interest. This is because the unpaid interest is added to the principal, and interest is then charged on this new, larger amount. The more time that passes without reducing the principal, the more the debt grows, creating a snowball effect that can quickly get out of control. Over several years, a debt that might have seemed manageable initially can become a financial burden, costing thousands of dollars more than the original amount borrowed.

The consequence of high-interest debt is that it diverts money away from more productive financial activities. Every dollar spent on interest is a dollar that is not being used to build your wealth. Instead of contributing to a savings account, an investment portfolio, or a retirement fund where your money has the potential to grow and earn returns, you are paying interest to lenders. For example, if you redirected $200 a month from debt payments to an investment earning a modest 5% annual return, you could accumulate over $50,000 in 15 years. This demonstrates the actual cost of debt beyond the immediate financial strain—it limits your ability to build a secure financial future and achieve your financial goals.

By prioritising debt reduction, you essentially “earn” a return equal to the interest rate you are paying on that debt. For instance, if you are paying off a loan with a 15% interest rate, reducing that debt is akin to achieving a 15% return on your money—a return that is both guaranteed and risk-free. This is especially powerful compared to the volatile nature of other investments, which may not always guarantee such high returns.

Reducing debt also improves cash flow. When you have fewer debt repayments, a larger portion of your income becomes discretionary. This means you have more flexibility to allocate funds towards investments, savings, or other financial priorities that can help you grow your wealth and prepare for retirement.

It does require a strategic approach. Start by identifying all your debts and their respective interest rates. Focus on paying down high-interest debt first, such as credit card debt, while making minimum payments on lower-interest debts. This method, known as the “avalanche method,” minimises the amount of interest paid over time and accelerates debt reduction.

Simultaneously, consider creating a budget that allocates a portion of your income to debt repayment while allowing for savings and investments. An emergency fund is also crucial; it ensures that you don’t have to rely on credit when unexpected expenses arise, preventing the cycle of debt from starting anew.

The idea of debt reduction can be overwhelming. Knowing where to start on what debt to prioritise first is not something to be taken lightly. Consulting with a financial planner will help you get your debt under control. A financial planner will examine your situation strategically and quickly assess the most prudent strategy to prioritise debt reduction and begin investing.

In future articles, we will shine a spotlight on the power of compounding interest. It can work against you when you have debt linked to high interest loans or credit cards. Compounding interest will work for you when the debt is reduced and money is invested in higher-interest-earning mechanisms.

By managing debt effectively, you unlock the potential to invest more in your future, harness the power of compounding, and reduce financial stress. Remember, every dollar you pay off today is a dollar—and then some—that you can invest in your tomorrow.

Step Up Financial Group is a team of qualified financial specialists. Every year, we help hundreds of Australians create financial stability and resilience while building toward a confident retirement. Contact us today for experienced, compassionate, and professional financial planning advice.