Keeping the lid on debt
August 2010
If you look at a typical life plan, you can see that for substantial periods of time most of us carry some debts. These debts could be relatively short-term, such as when we buy a car, or long-term like buying a house.
Cash is King
Whenever you can pay cash, it may pay to do so. For larger purchases this may not be practical, but if you read the small print, some companies make more money out of their financing deals than they do out of the products they sell.
Easier said than done, but it can work out a lot cheaper if you save before you buy. Let’s look at some of the more practical implications of the costs of borrowing.
The two key factors that affect the cost of borrowing are the Annual Percentage Rate (APR) on money borrowed, and the length of time (term) over which you borrow it.
So the higher the APR and the longer the term, the more you may have to pay back – and there can be a huge difference in the rates you pay and the overall cost of the loan.
Some basic rules are:
- Don’t borrow for longer than the life of the item you buy
- Plan ahead - saving up if you can - and shop around when choosing products
The chart below shows the effect of APR and term on the cost of borrowing. (These rates are only illustrations; many offered can be much higher.)
£10,000 over 5 years (APR of 7.5%)
Monthly repayment of: £200.38
Interest: £2,022
Total Repayment £12,022
£10,000 over 10 years (APR of 7.5%)
Monthly repayment of: £118.70
Interest: £4,244
Total Repayment £14,244
£10,000 over 5 years (APR of 15%)
Monthly repayment of: £237.90
Interest: £4,273
Total Repayment £14,273
As you can see doubling the APR and the term more than doubles the interest that you pay - effectively the cost of the loan. An extra 40% loading on the cost of the item, makes you think doesn’t it? Even in these low interest times, the cost of borrowing is high - especially on credit cards.
Your credit rating
All this of course assumes that you are able to borrow the money in the first place. Even credit card offerings are in shorter supply these days, and the rate you pay will be affected by your credit rating.
Your credit rating may affect your ability to borrow money and is derived from:
1) A 'score' based on your individual circumstances, for example, are you a home owner or do you rent? Are you in work or unemployed?
2) A credit reference check looking at your credit history; have you missed any payments on your loans or credit cards and if you have had any County Court Judgments (CCJs) registered against you.
The score helps the lender or credit provider decide whether to lend you the money, and can affect the interest rate you are offered. It's important that your score is as good as it possibly can be.
See our article 10 ways to improve your credit rating.
If you are refused a loan or feel that you are being marked down, you can obtain a copy of your credit report which should show you why. For example, they may consider that you have too much debt already, either as one large debt or numerous smaller debts.
So before you go out on your next shopping spree and ‘bash the plastic’, it’s worth looking at some of the pros and cons of different ways you can borrow money.
Credit card debt
Many of us rely on short-term borrowing on credit cards and store cards. These can be a very expensive way to borrow money over any length of time. Store cards, in particular, tend to have very high APRs.
You have to weigh up very carefully the benefits and drawbacks. Yes, you can buy what you want, when you want it – but at what cost? Would it not be better to wait?
Many people use credit cards well and find they can switch to better rates or clear their balances every month, but that takes some financial management, and card providers rely on our apathy to make their money. And eventually the debt has to be paid off.
Bank and building society overdrafts
An authorised overdraft may be a relatively inexpensive way to borrow money over the short to medium-term, but it is wise to be fully aware of exactly what you are paying back over the term of your borrowing.
It is important too, to stick within the limits agreed with your bank or building society. Unauthorised borrowing can be extremely expensive.
Borrowing to buy a house
Mortgages are not often ranked alongside other forms of borrowing. Many people don’t even regard a mortgage as a debt. But that is precisely what it is. A debt that may run for the best part of our lives and involves the single biggest asset most of us will ever possess.
The recent changes in the property and mortgage market have made it far more difficult to secure a mortgage. A deposit of between 10% and 25% is usually required before you start, with the best available deals usually requiring more.
Once a deposit is in place, borrowers will typically be able to borrow three and a half times one income plus one times the other borrower's income, or two and a half times the joint income - whichever amount is the greater over a period of up to 25 years or retirement age (typical). However, income multiples are used less these days and lending is more likely to be linked to affordability. So if you are indebted already this will probably reduce the amount you can borrow. This is when your credit rating can really influence what and who will lend you the money and give you the best deal.
The mortgage minefield
You may need the help of an expert mortgage broker to find the mortgage that’s right for you.
You have to choose the ‘type’ of interest rate you want and also the overall repayment structure. Here are some of the main types of interest variants available:
Standard variable
A standard variable mortgage tends to follow the basic loan rates of the bank or building society involved, usually at a margin above the prevailing Bank of England base rate. Since these can alter month by month, you must expect some variation in the amount you pay over time.
Fixed
If it’s important to know exactly where you stand because you are on a fixed income for example, and can’t see your circumstances changing in the future, then you might want to consider a fixed rate mortgage.
Here the bank or building society makes a long-term calculation on the future of interest rates, and offers you a rate accordingly. If they get their calculations wrong you could be better off. But you should be aware that you could be paying a premium for peace of mind.
Tracker
Tracker mortgages, similar to standard variable, are pegged to movements in the base rate. The advantage here is that although rates may vary, as soon as a change in the Bank of England base rate is announced, you can recalculate what you have to repay every month, up or down.
Discounted
Discounted mortgages are usually relatively short-term promotion deals which may offer you a rate for one to two years or more. These may sometimes even be below the base rate. At the end of the term you are usually rolled over into the bank or building society’s standard variable rate for the rest of your loan period.
Capped
Capped mortgages work in a similar way to variable mortgages, in that they usually rise and fall in line with the base rate. However, the lender promises that whatever happens to the base rate, your repayments won’t exceed a certain level. This could prove useful if you are working to a budget.
Offset
Since you get less interest for your savings than you usually pay on your debts, it seems like a smart idea to play one off against the other. In an offset mortgage, a savings account is linked to a mortgage, but instead of you earning interest on your savings, your money is used to reduce the balance of your mortgage and therefore the amount of interest that you owe.
As you can see, there are quite a few types of mortgage available, and picking the best one can involve some complex calculations.
Repaying your mortgage
Fortunately, repaying your mortgage is a lot simpler. In essence there are only two main types of mortgage repayment; a repayment mortgage and an interest-only mortgage. But it’s important to understand the difference between the two and how this may affect you.
Repayment
As the name suggests, with a repayment mortgage your monthly repayments are designed to gradually repay your loan over an agreed period.
The usual term is usually 25 years, though this could be less if you are over 50 or can afford and want to pay the capital off sooner.
25 years may seem an awfully long time and you may be alarmed to discover you are probably paying back over three times the amount you are borrowing. But then, you have to remember that in 25 years time, the value of your property will hopefully have increased too!
Interest-only
With an interest-only mortgage you repay your mortgage loan in one lump sum at the end of the loan period, or when you sell your house.
This reduces the monthly repayment amount, and suits some people who have no intention of living in the same house for 25 years - and in many cases cannot afford to repay the capital in the earlier years.
However this risky approach to financing a home purchase means you will need to find the money at the end of the term to pay the loan back, and you need to be very clear regarding some of the pitfalls. You really should take advice before embarking on this option.
If you are considering a new deal or are moving house, you should shop around. Your existing lender may offer you a good deal to keep your custom, so weigh up the options.
Remember, if you don’t keep up the repayments on your mortgage, the bank or building society could ultimately repossess your home.
A word to the wise
Here’s a brief checklist on borrowing:
Shop around when choosing products. There are deals to be had on everything; from fancy goods to financial services.
Keep track of your finances. That way you’ll know what you can afford and what is out of reach and will drive you into the red.
Compare ‘APR’ rates when choosing financial products and consider the length of the loan. It can really affect the amount you have to repay. Generally, it’s much better if you can plan well ahead.
Be careful not to over-extend yourself, you might find yourself out on a limb money-wise. Make sure you build in a safety margin in case things go wrong.
Keep up your payments on your mortgage – otherwise you could lose your home. If you do fall behind, be proactive. Talk to your lender and they will be glad to see that you took the initiative. They may in some cases be willing to let you re-mortgage or re-finance and extend the term of the loan. It is always good to seek advice.
Think about what might happen if your circumstances change. Would you be able to afford your repayments? Could you make ends meet? What steps should you take to make sure you are covered if you lose your job? Should you consider some form of income protection plan?
