Your money: First, pay off your debts

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The Independent Culture
In the second of an eight-part series on financial planning, Rachel Fixsen points out that there is little point in saving if you are still paying interest on borrowings

One of the best investments you can make is to pay off your debts. You could spend hours trawling through league tables of the best performing investment funds, but would be hard pushed to find a rate of return as high as the interest you pay on your storecard borrowings.

It can seem demoralising to use a windfall to pay off debts. You would rather have it sitting in a savings account, making you feel rich, than see it swallowed up in the void that is your debts. But keeping both savings and debts makes as little sense as actually going out and borrowing money in order to invest it. Of course, this is precisely how City whizzkids make their millions. But the small investor is unlikely to have the resources or know-how to make this high-risk strategy work.

Financial advisers often say clients are just not aware of the cost of borrowing from credit cards. Some card issuers charge a crippling 29 per cent in annual interest. And storecards can be even worse. Laura Ashley and Monsoon charge 31.8 per cent in annual interest on outstanding balances on their storecards after the initial interest-free period.

"If someone wants to save money, they should get rid of their debts in the first place," says Dawn Slater, of independent financial advisers Dawn Slater Associates in Newbury.

Banks charge between nine and 20 percent in annual interest on authorised overdrafts, according to Moneyfacts, the financial information provider. And watch out for unauthorised overdrafts, which can cost as much as 32 per cent.

Compare these rates with some high-yielding investments. Top rates for a Tessa (tax-exempt special savings accounts) are 8 per cent. Even an equities unit trust, which is relatively risky, would be unlikely to have given you an average annual return of more than 15 per cent over the last five years.

However, there is a case for putting down long-term savings while still using a credit card for convenience. "Some people need the discipline of regular long-term savings, say an endowment or PEP, while having some short-term debt on credit cards," says Jim Preston, of Wesleyan Financial Services.

If you do intend to keep using a credit card, switch to one which has a low interest rate. A Mastercard or Visa from The People's Bank Connecticut, for example, charges just 16.9 per cent interest. Read terms and conditions of credit cards carefully, as they can vary widely.

But what about major borrowings, such as your mortgage? Because mortgages are secured loans, the rate of interest you pay is normally quite low. So paying this off may not be as urgent as some car loans or personal loans. But you could still save interest by using any lump sums to pay it off.

If you have equity in your home and are carrying around debts, it might make sense to remortgage and use the additional money borrowed to repay any high-interest debts. By shopping around, you may be able to lower your mortgage rate at the same time, says Slater. But remember, it is a good idea to seek independent advice on remortgaging.

You have to be careful when repaying some of your mortgage over and above your set monthly repayments. There may be penalties for doing this, especially if you received an incentive, such as "cash back", when you took the mortgage out. Make sure you make any extra repayment at the right time of year. With many mortgages extra capital repaid is only added to your account once a year, so any repaid before then doesn't reduce your interest.

Don't use emergency savings to repay your mortgage. Once you have used money to reduce your outstanding mortgage, it takes time to get at that money again. You should always keep savings for an emergency easily accessible.

Virgin Direct has a product which works on this principle that having assets and debt simultaneously is a waste of money. The Virgin One account is basically a single account which you can use for borrowing - including your mortgage - savings and as a current account. The account is always in net debit, because of the mortgage, so this means savings effectively receive tax-free interest. And the credit balance you normally carry on your current account goes to work straight away to minimise your mortgage and, therefore, your interest bill.

This type of account does not appeal to everyone. "Some people say `I like to keep my money in different blocks, that way I have more control'," says Jayne-Anne Gadhia, managing director of Virgin One account.

"It is a personal choice, but the bottom line is you're losing money if you have savings and borrowings separately," she says.

Dawn Slater Associates: 01635 45325; Wesleyan Financial Services: 0800 22 88 55. `The Independent' has published a free guide, `Making Your Investments Work for You'. The guide, which covers every aspect of financial planning, including paying off a mortgage, retirement and every aspect of investment, is sponsored by Wesleyan Financial Services. To obtain your copy, call 0800 1379749 or fill in the coupon on this page.