Your debts are someone else’s assets
Debt may be a necessity for most of us, mainly to buy a home, but the interest repayments are hampering your ability to save towards your financial goals. The sooner you can be debt-free, the sooner you can work towards your financial independence.
The company that loaned you money wants a steady income from your debt, so it is often not in their interests to help you to repay the debt sooner. Nevertheless, you can usually may extra payments towards debts, which will help you to pay the capital owed off sooner.
If you save £100 and add interest of 10% on this, after 1 year you will have £110. If in year 2 you add another 10% interest, you will have £121. Thus, your interest will be earning interest. This is compound interest in action. With debts this force of nature is working in someone else’s favour, not yours, so you need to reduce the power of the compound interest as quickly as you can afford to.
Some debts are more expensive than others
It goes without saying that this is true. In general, the less risky you are as a borrower, the cheaper the debt will be, and if the debt is secured against an asset, then this makes it even safer, and therefore cheaper.
The downside is that you lose control over your asset. To give you an example, you do not own a mortgaged house - your mortgage company does (which is why some hold the deeds). It only becomes fully your asset once the loan is repaid.
In general, mortgages are fairly cheap in percentage terms, personal loans are more expensive, and credit cards are even more expensive. However, you need to take into account the term of the loan, as you can end up paying more in the long run with a cheaper long-term loan than an expensive short-term loan. This is the power of compound interest.
Making minimum repayments
It is common, especially with credit cards, for a provider to insist that you make minimum debt repayments. It can seem attractive to simply make these repayments because they keep your outgoings low. However, in the long run this will make you pay more interest.
For example, it is typical for a credit card to require repayments of 2% to 3% per year. This payment would result in only a small proportion of the debt being repaid, the majority being interest. This can mean that you would take many years to clear the debt. When you consider the very high interest rates on credit cards, this can mean thousands of pounds in extra interest.
The effect of overpaying
If you can overpay on your debt, even by a small amount each month, this can reverse the effect of compound interest. The overpayment (if allowed by your contract), will reduce the balance quicker, leading to less interest being paid.
You should always bear in mind that your debts may have penalties to redeem the balance. We advise that you examine your contract carefully!
Also, different contracts will calculate interest in different ways, so you need to be careful in your calculations. Each loan will give a comparative indicator, called the APR (annual percentage rate). This will give a percentage annual rate based on the total charges for the scheme.
Which debt to repay first?
The general advice is to pay the minimum allowable on each debt, and then to combine all your remaining resources into the repayment of one debt at a time, to repay this as quickly as possible. Normally, we would recommend that you repay the debt with the greatest interest first.
In these examples we have assumed that interest is applied monthly and there is no penalty for making regular overpayments.
Credit card balance: £5,000
Interest rate: 25%
Minimum repayment: 2.5%
Monthly repayment: £125.00
Total interest: £5,862.28
Total repaid: £10,862.28
Paid off in: 7 years and 3 months
Extra monthly repayment: £25.00
Interest saved: £2,236.78
Paid off: 2 years 5 months early
Extra monthly repayment: £125.00
Interest saved: £4,326.86
Paid off: 5 years early
Equivalent tax-free growth
If you were to calculate the amount your overpayments would have to grow by each year to generate the interest saved, this equates to a tax-free growth figure. In the case of example 2, this equates to a growth of 57%. There are few ‘investments’ that could promise this level of ‘growth’.