Clearing your debts is the best way to save

Pay off what you owe with care and you will be better off, says Jenne Mannion
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The Independent Online

Paying off debts seems an unexciting way to spend spare cash but, in terms of getting your finances in order, it is one of the most sensible things. Most people have some debt, whether credit cards, personal loans or mortgages. And this level of debt is huge. British consumers owe more than a trillion pounds on cards, mortgages and loans, according to the Bank of England.

Even though interest rates are at historically low levels, these debts are stinging you in the form of interest that will continue to accumulate and compound until you manage to get yourself back in the black. And there seems to be a trend toward higher interest rates.

Paul Ilott, an independent financial adviser at Bates Investment Services, based in Leeds, says provided you have put aside some "rainy day" money, then it almost always makes sense to pay off debt first, rather than build up savings.

Usually, it is the case that your money is better spent reducing any debt than it would be if you hold the same amount of money in even one of the best interest-bearing savings accounts. The obvious reason for this is that generally the cost of borrowing money is more than what you can earn from a savings account. The current average standard variable rate for mortgages is 6.75 per cent, rather higher than all but the very best savings accounts, and the rates on credit cards are higher still.

Although there is a lot of competition among credit cards and you can often access interest-free deals for shorter periods, the standard variable rate tends to be about 16-20 per cent per annum. Store cards are even more excessive. Earlier this year, the Office of Fair Trading found that store cards charged an APR about 10 per centage points above standard credit cards. Some store cards, such as Debenhams and Toys R Us, have APRs of an exorbitant 29.9 per cent.

Not only are interest rates high, you must consider the impact of tax on your savings; this means the gross interest rate earned on a savings account must be much higher to equal the same impact it would have on reducing a loan. Based on the standard variable rate for mortgages of 6.75 per cent, a basic-rate taxpayer would have to earn 8.44 per cent on savings to achieve the same financial benefit of paying this amount off his or her mortgage. A higher-rate taxpayer would have to earn an interest rate of 11.25 per cent to achieve the same.

These figures relate to mortgages, one of the cheapest forms of borrowing. With the rate on credit cards, store cards and personal loans being much higher, the interest owed is accumulating at a much faster pace than the interest earned on even the most competitive savings accounts after tax.

Mr Ilott says it makes sense to pay off your most expensive forms of debt first. This is most likely to be credit and store cards, followed by personal loans and then the mortgage, though it is important to check the interest rates you are paying on each individual debt.

"It is also wise to pay off the smallest debt first. If you have two credit cards, one with a balance of £1,000 and the other with £3,000, charging the same interest rates, then focus on paying off the £1,000 debt first. Once that is achieved, look toward the next and direct the extra funds that were paying off that first credit card toward the second," Mr Ilott says.

John Fairhurst, managing director of Payplan, an adviser specialising in debt solutions, says the best way to tackle credit cards is by paying as much as you can, as early as possible. "One of the traps is that people just pay off the minimum required amount each month. Often, this is hardly more than the interest, so you are prolonging paying off the capital and accumulating a lot of interest in the mean time. Even increasing your payments by a modest amount on a regular basis can dramatically reduce the debt owed," he says.

Once unsecured debts such as credit cards and personal loans are paid off, the next step is attacking your mortgage. It used to be the case with longer-term debts, such as mortgages, that the effects of inflation helped to erode such debt. However, with much lower inflation, the burden of debt will be hanging around a lot longer.

A popular way to tackle your mortgage is by making lump-sum payments if, for example, you have accumulated money in your savings account or received a bonus or inheritance.

Mr Ilott says: "If you pay a chunk of the capital but keep making the same monthly payments, you will whittle away your debt much more quickly." Another way to pay off your mortgage quickly is to increase your regular mortgage repayments by an affordable amount.

Moneyextra Mortgages, a division of Chase de Vere, the Bath-based independent financial adviser, calculates that by increasing monthly payments by £100 on a £150,000, 25-year, flexible-repayment mortgage with a standard variable rate of 6.75 per cent, you will save £36,148.40 in interest and reduce the term by four years and 11 months. The more you can pay off early, the bigger the savings.

But Catherine Elphick, an adviser at MoneyExtra Mortgages, says it is vital to check whether there are any penalties for overpayments and the basis on which overpayments are calculated.

Most mortgages let you make a certain amount of overpayment without incurring a penalty. Often this is about 10 per cent of the total mortgage; or it may be a flat figure: for example, Nationwide offers a mortgage that enables its clients to pay £500 extra a month without penalties.

There are mortgages where there are no limits on overpayments, but these generally come with a higher interest rate.

Ms Elphick says the calculation basis is a further important consideration. While many mortgage providers re-calculate the balance owed daily and reduce the amount outstanding and hence the interest, others will not.

Alliance & Leicester has a mortgage that allows a single overpayment in January, but the amount is not credited until the following December. "Clearly there is little benefit in paying off this amount early and it could well make sense to have that lump sum sitting in an interest-bearing savings account instead," she says.

If you are paying a discount rate on your mortgage and have not used your cash Isa allowance, it could be more fruitful to put up to £3,000 in one of the more attractive mini cash Isas. The Abbey mini cash Isa pays an AER of 5.35 per cent, while the Yorkshire Building Society pays an AER of 5.15 per cent, whereas a discount mortgage rate could be as low as 4.75 per cent.

FACT FILE CUTTING DEBT

SHOP AROUND: Ensure that you pay the lowest interest on unsecured loans. Shift store and credit card debts with hefty interest rates to cheaper competitors.

REMORTGAGE: Too many people are paying the standard variable rate and could save thousands if they re-mortgaged.

PAY DOWN DEBT: After paying off smaller unsecured and often more expensive loans, use cash to reduce your mortgage.

SAVINGS: Don't have large savings sitting alongside your mortgage. Keep some money for a rainy day, but use the rest to pay a lump sum off your mortgage.

A painless way to reduce the mortgage

Stuart Joseph is doing his best to make a sizeable dent in his mortgage. The 25-year-old, who lives south of Bath with his partner, Claire Thomas, took out a £120,000 mortgage through Nationwide, fixed at 5.29 per cent per annum for five years, in March this year.

Under the terms of his mortgage, Stuart can pay an extra £500 per month without incurring penalties, and he is doing his best to do exactly that. Although the additional payments reduce the capital on his mortgage, the money is held as if in an offset account, so he has the comfort of knowing that he can access those funds if ever there were a need to do so.

"I do find making the additional payments difficult at times," he says, "but it is a case of priorities and I'm very keen to reduce my debt as much as possible.

"Under the terms of this arrangement, I'm far less likely to touch the money than I would if it were sitting in a conventional bank account."

Stuart wanted a mortgage that would be fixed over the long term and also offer flexibility; it was sourced for him by the independent financial adviser Moneyextra Mortgages. Stuart is a marketing manager for a financial services company.

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