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Should I save, consolidate my credit or pay off debt?

To save or pay off debt - that is the question!

Around one in three of us feel pressurised to take credit when it is offered and one in five have signed credit agreements they have later regretted, research by the Office of Fair Trading shows.

A majority of people quizzed by the regulator admitted to not always reading all of the small print when signing credit agreements. Given all of that it's perhaps not that surprising that as a nation we are more than £1 trillion in debt.

If you don't understand debt then you are liable to make mistakes and overpay for things you possibly don't need. Watchdogs are clear that our credit laws, which are currently in the process of being changed, very much need updating. Consumers need more protection against unscrupulous lenders and making it easier to challenge unfair or extortionate credit agreements.

Which?, formerly the Consumers' Association, says: 'Only transparent information and products will create a truly competitive market.' It wants to see credit cards only having one way of allocating interest on their cards so that people can better compare rates. It urges lenders to fully share customers' credit histories so as to ensure responsible lending and borrowing. It also wants an end to the automatic inclusion of Payment Protection Insurance in credit quotes which increases the cost of borrowing often without customers realising.

Switch and save
These are all excellent ideas, which would go some way to sorting out the debt crisis, but borrowers have to take responsibility too. And if borrowers take control then they are better able to sort out their debts and stop them ever turning into a crisis.

Currently most people simply overpay for their borrowing with analysis by Chase de Vere putting the overspend on debt as high as £35 billion a year. The debt waste builds up from mortgages, personal unsecured loans and credit cards and theoretically means every household could save as much as £2,700. Chase de Vere reckons the biggest savings come from mortgages with an average homeowner wasting £2,182 on a loan of around £100,000. The main winners would be those on standard variable rate deals moving to fixed or discount rates. Similarly on credit cards people with the traditional plastic charging around 16% on outstanding balances of £3,000 could be about £500 a year better off by moving to 0% rates. Personal loans rates are as low as 5.9% but many people are still paying as much as 12.9% at traditional providers instead of moving to the internet firms which are often cheaper.

However if simply getting a better deal on your debts can save you money, how much better off would you be just in getting rid of them? In the long-run you will have less money going out every month on repayments so will be better off. But does that mean you should always concentrate on paying off debts before doing anything else? Ideally everyone should have around three months' salary in savings to tide them over should a major expense arise or they end up losing their job or being unable to work through illness. If you do not have the three months savings then it makes sense to have it in place – or near enough – before you wipe out debts.

But with savings rates at the absolute best at 7% for regular savers with Abbey and Halifax and more likely around the 4% mark for most people it makes sense to get rid of debts. This is simply because debts currently cost you more than you make in savings. Someone making 5% a year on £100 savings would receive £5 a year before tax. If they owed £100 and were paying 10% interest on the sum it would cost them roughly £10 in the year in interest. Saving therefore makes less than paying off debts. The equation is simple enough with deposit account saving but less so with saving in ISAs or unit trusts where the risk of the investment means returns can be much higher than interest rates and, conversely, much lower or even be losses. And the equation becomes even more complicated with pension savings which attract tax relief at basic tax and higher rate tax rates. For £78 saved into a pension by a basic rate taxpayer the Inland Revenue throws in another £22. The same applies to higher rate taxpayers but at the higher rate of 40%.

Winning strategy
All of which makes the current obsession of using your house as your pension a bit more difficult to work out. Saving into a house by paying the mortgage off early and banking on house price rises to make you more money would over the last few years have been a winning strategy. With house prices rising at as much as 20% a year it made sense to get rid off your mortgage and invest in property. But mortgages no longer attract tax relief and house prices, like shares can go up as well as down. And out of all the debts you owe you are guaranteed that the lowest long-term rate you are paying is on your mortgage.

It makes sense to borrow when interest rates are relatively low - 4.75% at the end of 2004. People who can remember back to the early 1990s can recall rates hitting 15% at one stage. Borrowing then was not quite as good an idea. But when rates are low borrowing is sensible as long as it is controlled. Talk of a debt crisis is a bit overblown when around 80% of the UK's household debt is tied to houses and people are not struggling to keep up with payments. Nationwide Building Society says just around 2% of borrowers regularly have trouble keeping up with mortgages. The National Consumer Council is not quite as confident – it says around six million families are already struggling to keep on top of their credit commitments. It warns that anyone with more than four credit commitments or spending more than half of their pre-tax income on debt repayments is at risk.

The majority of people are not in that much trouble and are saving at least some of their money. The only trouble is that as figures show we are only saving a net 12 pence out of every pound we earn. We are a nation of credit junkies happy to borrow money while interest rates are low. Whether we have the sense to pay off those debts once interest rates start rising is the tougher question.

Check out some of these links for more information on where to go for help if you have a debt problem






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