Back in March of 2018, the Office for National Statistics showed that the average saving rate in the UK fell to 4.9% for the year which was a decrease from 7% the year before. This is also the lowest saving rate we have seen since 1963.
In addition to this savings fall, the unsecured consumer credit was up 9.4%, and credit card borrowing was up 9.6%.
This is leading to a situation where individuals are using their savings, and borrowing more to sustain their levels of spending.
If you are looking to achieve financial independence, this is worrying reading.
Technically, this is worse than living pay check to pay check, as borrowing is creeping up to levels seen in the previous Financial Crisis.
Household debt-to-income ratio is now at 133%, compared to 150% in the crisis.
Having debt can be beneficial for certain purchases such as a mortgage, but debt comes with potentially significant interest rates, and can inhibit the saving or investment you are able to achieve with your current income.
This is why you need to take control of your debts immediately, and get yourself back on track!
This isn’t a blog post telling you to continue paying the minimum amount each month for the entire term; this is telling you that your debt is a serious issue, and you need to do everything you can to get yourself free of this debt as quickly as you can.
Here is a relatable situation:
You and your partner work full time jobs, and have £6000 of credit card debt which you are servicing each month with the minimum payments.
At a 20% APR, this is costing you both £1200 every year in interest alone.
Rather than pay off the loan, you both go for a three course meal at a nice restaurant costing £100, and have multiple subscriptions each month to Amazon Prime, Spotify, Sky TV etc.
You are comfortable because you are able to do all the things they want, and continue to pay the minimum amount on the card off, as your income pays for this lifestyle exactly.
BUT, the interest payments on the total loan amount mean that you are £1200 worse off every year if you decide to continue paying the minimum amount.
Why would you choose to pay £1200 each year for the privilege of holding debt to someone else?
Pay Quickly, Pay Less
The fact you have debt should be ringing alarm bells. It means “there was a time when I was spending MORE than I was earning”.
The most rational response when understanding the cost of servicing debt is “I need to get myself in a situation where I have paid off this overspending, and am now debt neutral”.
This could mean cutting out restaurant visits, cancelling entertainment spends, or selling unwanted items in the home to pay down this toxic debt immediately as a priority.
Every single pound that is not going to household expenses which are necessary (electricity, gas, water, rent/mortgage), should be put into the debt until it is entirely gone.
Forget the comfortable convenience of paying monthly amounts, and take the approach that you will focus on removing this £1200 interest expense each year as soon as possible, as this will free up funds in the future for more extravagant purchases or smart investments.
This interest payment is money you earned, being taken from your pocket for no good reason!
Additionally, for those who have savings: If you cannot save at a rate better than the interest that you are paying for your loans, then you should not be saving until your debt is paid!
I will cover two methods that are commonly used to pay down debt. Let’s define a potential debt portfolio:
- Loan 1: £1000, with £100 minimum payment per month, 5% interest rate
- Loan 2: £4000, with £450 minimum payment per month, 8% interest rate
This method was popularised by Dave Ramsey, and aims to pay down debts in order of the remaining balance.
The downside is that the largest loans which might have the highest interest rates will incur larger interest payments over the life of the loan, but comes with the psychological benefit of getting rid of debt accounts quicker.
In the example above, let’s say you received a windfall/bonus of £1450. With the Snowball Method, you would pay the minimum amount for Loan 1 and Loan 2 (£100 + £450 = £550), and be left with £900. You would then pay off Loan 1 entirely.
By paying off the loan with the 5% interest, you would be saving yourself £45 per year.
This method of paying off debts looks to pay down debts in terms of interest rate.
The benefit is that you minimise the total cost of interest payments across the life of both loans, but you still have to service two loans each month.
With the same windfall of £1450, you service the minimum payments on both loans, and then put £900 into Loan 2 at 8% interest.
Both loans still exist, but you will be paying £900 less at 8% interest which saves £72 per year.
Some loans can have very favourable savings rates, so one might say “well I have a 3% interest rate on my loan, but make 8% every year in the stock market”.
In this case, you are comparing a guaranteed return by paying the debt (3% per year), vs the uncertainty of your portfolio returns being greater than 3% to continue making a net gain.
If you have the appetite for risk, and can earn more from holding this debt, then that is your choice, but we believe that you should be becoming debt neutral as a priority.
If you have the funds to invest in the stock market, then you probably have the capacity to pay down the debt as an emergency too!
The exception to this emergency rule is relating to Student Loans in the UK.
The loan is applied as more of a tax, and payment is only conditional on the graduate earning over a certain threshold, and even then, is only taken as a percentage of the gross salary.
There is no risk of default, and the loan can be cancelled if the full amount is not paid after 25 years from the first April of Graduation (if you started between 2006 and 2011), or 30 years after if it was after 2011.