Stage two: ditch your debt
Up to 4.7 million adults admit they are still paying off last year’s Christmas costs, according to money.co.uk, but in order for 2010 to be a true fresh start, you’ll have to clear any outstanding debt or get your debt repayments in order.
Before you start making plans to tackle your debts, it’s essential you draw up a budget so you understand exactly what all your financial commitments are. An accurate budget will also highlight areas where you can cut back – for example, reducing your shopping bill or finding a more competitive insurance policy.
Read part one of Moneywise’s Financial Feelgood plan to find out the best way to write a budget.
Next, you should prioritise which debts to pay off first, based on what you stand to lose through non-payment.
Secured debt is where the lender safeguards the money they have lent you against something of value that you own.
Mortgages are an example of a secured loan, which means you could face losing your home if you can’t meet the repayments. So make sure you pay your mortgage every month, but also consider making overpayments to clear the debt quicker.
Making mortgage overpayments will reduce your overall mortgage term and the total amount of interest you pay on the loan. It will also protect any equity you have in your home and help create a buffer against negative equity – where mortgage debt is more than the value of a property.
Negative equity isn’t just a problem if you need to sell your home; it will also prevent you from moving onto a new mortgage deal once your initial discount or fixed period ends.
This mean you could end up being stuck on your lender’s SVR – and while this might be pretty cheap at the moment, once the Bank of England starts to increase the base rate, your repayments will increase, possibly quite sharply.
According to price comparison website moneysupermarket.com, the average standard variable rate (SVR) deal is now 4.2% above base rate, compared with 2.68% a year ago.
“Borrowers need to be aware that lenders are free to price their SVR as they please, and therefore an SVR deal might not be the best way to get the most benefit from the low base-rate environment,” warns Hannah Mercedes-Skenfield, mortgages channel manager at moneysupermarket.com.
If you have built up at least 20% equity in your home, Mercedes-Skenfield says it’s likely that you will be able to find a better rate on a three-year fixed deal.
Even if you aren’t at risk of negative equity or looking to move, then you should still be aware of the danger posed by house price falls. Just as first-time buyers need to put down a deposit of 25% to benefit from the most competitive mortgage rates, people remortgaging onto new deals are required to have a decent equity stake in their homes.
Lenders take the loan to value (LTV) – that is, the amount you need to borrow versus the value of your home – into account when they price mortgages. So, if you have a 40% equity stake in your property (meaning you require a 60% LTV mortgage) then you are likely to be offered the best rates by lenders. If your LTV is 75%, you will probably be offered a slightly less competitive deal and so on.
House price falls could see you move from one LTV band into another – meaning you risk having to pay more on your next mortgage. By making overpayments you could potentially offset house price falls, and save yourself money down the line.
However, unless you are on your lender’s SVR, you may be restricted from making overpayments. Check your mortgage document or call your lender to find out how much you are allowed to overpay each year, and whether any penalty charges apply.
If you are able to remortgage, then make sure you compare all the costs associated with the various mortgage deals available - don’t be tempted to scroll down the list of lenders looking for the one with the lowest headline rate. Apart from the fact that different lenders use different criteria to select (and reject) borrowers, there are a number of expenses to take into account that can significantly add to the total cost of a mortgage.
For example, arrangement fees can be anything from £1,000 to nothing at all.
Moneywise’s True Cost mortgage tool allows you to not only hunt out the best mortgage deals, but also to understand exactly how they compare when it comes to fees.
If you are struggling to meet your mortgage commitments, then you should speak to your lender as soon as possible.
Credit cards remain a popular choice for many peope. Of course, if you don’t pay your card, you won’t necessarily lose your home or other assets, but interest rates are high and you’re credit rating will be affected.
When money is tight, it’s tempting to just pay the minimum amount off your card each month – nearly a third (31%) of credit card holders don’t plan to pay off their credit card balance within the next six months, according to moneysupermarket.com. But this could be a costly mistake in the long run.
By increasing your repayments you can cut the overall amount you owe and reduce the amount of time it takes to clear this.
For example, a borrower with a £1,000 balance on a credit card at 16.9% APR who pays the minimum repayment of 2% for 12 months, will rack up £151.74 in interest – and only bring the total debt down to £920.60 – according to research by moneysupermarket.com.
But the same customer could slash their overall balance by nearly £400 and pay nearly £30 less in interest by increasing their repayments to 5% (£50) per month. Paying 10% per month (£100) would enable the borrower to clear their debt in 12 months and only pay £79.16 in interest.
Falling victim to a sneaky payment method that the vast majority of credit card providers employ could also cost you dearly.
Most credit card providers use a payment structure known as negative payment hierarchy to clear debts from your card. Simply put, while you might consider your credit card debt as one lump sum, your provider won’t. So, your balance transfer debt will be considered as separate to your purchase debt or cash withdrawals.
This means that when you make payments, your money will not be used to pay off the debt as a whole. Instead, your provider will use your payments to clear the cheapest balances first – otherwise known as negative payment hierarchy.
Imagine you have a credit card with a £1,000 balance bought over from a previous credit card and a £500 balance of new purchases. The balance transfer element of your debt is currently interest-free, whereas you are being charged 17% APR on your purchases debt.
Let’s say you make a payment of £500. While you might assume this will clear your purchase debt, leaving you able to pay off your balance transfer without attracting any interest, this is not the case.
With a negative payment hierarchy credit card, you will need to make two months’ payments of £500 before your balance transfer is paid off. In the meanwhile, your £500 purchase balance is attracting interest of 17%.
There are two ways to avoid negative payment hierarchy. The easiest way is to use separate cards for spending and clearing your balance. Or you could opt for a card provider that uses positive payment hierarchy – either Nationwide or Saga. However, their card offerings might not be right for you, so make sure you consider all the factors before you sign up.
Personal loans and overdrafts
Credit cards tend to have higher interest rate charges than other types of unsecured loans, which is why any extra cash you have will (in most cases) be best off used to clear this debt.
However, this is not always the case and, regardless, it’s important not to miss any loan repayments as the charges will only increase to your worries.
With personal loans, the longer the term the more you will pay in interest overall.
For example, if you borrow £10,000 over fi ve years at an APR of 7.9%, you’ll have to pay back £200.99 a month, which comes to a total of £12,059.19. If you borrow the same amount at the same interest rate over seven years, your monthly payments will fall to £154.01 but you’ll pay back £12,937.12 altogether, which is £877.93 more.
In some cases, you may be in a position to repay the full loan amount early – perhaps because of a cash windfall or because you’ve decided to take out a more competitive loan elsewhere.
However, your loan provider might charge you an early repayment (or redemption) charge for doing so.
This should be no more than two months’ interest on the outstanding amount. Not all loan providers charge early repayment fees, so check the small print.
Overdrafts, meanwhile, are not really a type of loan but instead represent the amount of money you can still access when you have no money in your account. So if you have a £1,000 overdraft limit you can keep spending up to that limit.
You will be charged interest on the amount you are overdrawn, although some banks offer 0% overdrafts for a certain period of time or up to a certain limit. Most of the big banks offer overdrafts.
If you are being heavily charged on your current bank overdraft, then consider moving your current account to a different provider that offers a competitive deal. Or, depending on the interest rates involved, it might be best to use a personal loan to clear your overdraft.
If your debts are spinning out of control there are routes you can take, including bankruptcy or an individual voluntary arrangement.
Changing mortgages without moving home. Property owners chiefly remortgage to get a better deal but some do so to release equity in their homes or to finance home improvements, the costs of which are added to the new mortgage. Even though you’re not moving house, you still need to engage solicitors, conveyancing and the new lender will require the property to be surveyed and valued.
An overdraft is an agreement with your bank that authorises you to withdraw more funds from your account than you have deposited in it. Many banks charge for this privilege either as a fixed fee or charge interest on the money overdrawn at a special high rate. Some banks charge a fee and interest. And other banks offer a free overdraft but impose very high charges for exceeding the agreed limit of your overdraft.
As the name suggests, secured loans require security, or “collateral”, usually in the form of property, a motor vehicle, or another valuable item, as a guarantee for the loan. This effectively reduces the level of risk to which a lender is exposed, as the lender has a claim against your home, or other effects, if you default. Secured loans are often available at competitive interest rates. Types of secured loans include mortgages, logbook loans and some types of hire purchase where the loan is secured on the goods you’re buying and these are repossessed if you default.
Every mortgage lender has a standard variable rate of interest, or SVR, on which it bases all its mortgage deals, including fixed and discounted rate and tracker mortgages. When special deals come to an end, the terms of the deal usually state that the borrower has to pay the lender’s SVR for a period of time or pay redemption penalties. The lender’s SVR is, in turn, based on the Bank of England’s base lending rate decided by the Bank’s Monetary Policy Committee (MPC). Every time the MPC raises its rate, mortgage lenders generally increase their SVR by the same amount but when the MPC lowers its rate, lenders are often slow to pass this on or don’t pass on the full cut to borrowers.
An unexpected one-off financial gain in cash or shares, generally when mutual building societies convert to stock market-quoted banks. Also windfall tax, a one-off tax imposed by government. The UK government applied such a measure in the Budget of July 1997 on the profits of privatised utilities companies.
The circumstances in which a property is worth less than the outstanding mortgage debt secured on it. Although it traps householders in their properties, the Council of Mortgage Lenders (CML) says there is no causal link between negative equity and mortgage repayment problems. At the depth of the last housing market recession in 1993, the CML estimated 1.5 million UK households had negative equity but most homeowners sat tight, continued to pay their mortgages and eventually recovered their equity position.
An account opened with a clearing bank (few building societies offer current accounts) that provides the ability to draw cash (usually via a debit card) or cheques from the account. Some pay fairly minimal rates of interest if the account is in credit. Most current accounts insist your monthly income (salary or pension) is paid directly in each month and they offer a number of optional services – such as overdrafts and charge cards – which are negotiable but will incur fees.
A person (or business) unable to pay the debts it owes creditors can either volunteer or be forced into bankruptcy – a legal proceeding where an insolvent person can be relieved of their financial obligations – but loses control over their bank accounts. Bankruptcy is not a soft option. Although it may wipe the financial slate clean, it is extremely harmful to a person’s credit rating (it will stay on your credit record for six years) and will adversely affect your future dealings with financial institutions. Bankruptcy costs £600 paid upfront.
Moving money from one account to another, whether switching bank accounts or more likely transferring the outstanding balance on your credit card to another card that charges a lower – or 0% – rate of interest. Some card providers may charge a transfer fee that can be a percentage of the balance transferred.
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.
Used by the holder to buy goods and services, credit cards also have a monthly or annual spending limit, which may be raised or lowered depending on the creditworthiness of the cardholder. But unlike charge cards, borrowers aren’t forced to pay the balance off in full every month and, as long as they make a stated minimum payment, can carry a balance from one month to the next, generating compound interest. As the issuing company is effectively giving you a short-term loan, most credit cards have variable and relatively high interest rates. Allowing the interest to compound for too long may result in dire financial straits.
This is used to compare interest rates for borrowing. It is the total (or “gross”) interest you’ll pay over the life of a loan, including charges and fees. For credit cards where interest is charged at more frequent intervals, the APR includes a “compounding” effect (paying interest on interest). So for a credit card charging 2% interest a month (equating to 24% a year), the APR would actually be 26.82%.
Loan to value
The LTV shows how much of a property is being financed and is also a way to tell how much equity you have in a property. The higher the LTV ratio the greater the risk for the lender, so borrowers with small deposits or not much equity in the property will be charged higher interest rates than borrowers with large deposits. The LTV ratio is calculated by dividing the loan value by the property value and then multiplying by 100. For example, a £140,000 loan on a £200,000 property is a LTV of 70%.