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Introduction to Borrowing


Introduction

Almost all of us need to borrow money at some point in our lives. Whether it's to buy a home, cope with a financial crisis or simply cover periods when you're spending more than you earn, borrowing provides a convenient way to get money today that you can pay back over coming days, months or years.

There's nothing generally wrong with borrowing provided it's at a reasonable rate and you can comfortably afford to pay it back. Problems arise if you over extend yourself and/or borrow at sky high rates of interest. Unfortunately, the UK has very high levels of personal borrowing, as the figures above show.


The cost of borrowing - Interest

When you borrow money from someone they'll usually want some extra money, called 'interest', when you pay them back. This is because:

  1. They could have put the money in a bank savings account instead and earned some extra cash.
  2. There's a risk you won't pay them back (this is called 'credit risk'). The greater they think the credit risk is the more interest they'll want to make the risk worthwhile.

Interest, which is usually charged either daily, monthly or annually, is quoted as an annual percentage rate. For example, an interest rate of 12% per annum (p.a.) means you'll have to pay 12p each year for every £1 borrowed. However, your effective cost of borrowing also depends on how frequently you pay interest and/or repay the sum borrowed. Lenders might also charge other fees, e.g. an arrangement fee, which can add to your overall borrowing costs.

Fortunately, when lenders offer a loan they must show an Annual Percentage Rate (APR). This reflects most costs along with how frequently you pay interest and repay the loan, helping you compare various offers on a level playing field.

Be warned, if you can't afford or defer your interest payments then your debt could spiral as you'll end up paying interest on the interest already charged (an effect called 'compounding'). This can be a really vicious circle and you should try to avoid at all costs.

The concept of compounding is really simple - you pay interest on the interest you've already been charged (but haven't paid). For example, if you borrow £100 at 12% (i.e. £12) interest in year 1 but don't pay that interest, you'll suffer interest in year 2 on £112 (equal to £13.44 at 12%). If you consistently fail to make your interest payments then compounding could, over time, cause your borrowing to soar beyond reach.

When you borrow money you might face other costs in addition to interest. The most common are administration fees, property valuation fees on a mortgage, option to purchase fee on a hire purchase agreement and other fees that a lender makes compulsory when your borrow money from them.

A 'hidden' cost when borrowing is how regularly interest is calculated and charged compared to how often you must repay the loan.

The Annual Percentage Rate (APR) takes the above factors into account to provide a single figure for the overall costs of borrowing, making comparison easier.

Mr Spender borrows £1,000 for 1 year at 12% interest, a total repayment of £1,120. If he makes a single payment at the end of the year the APR is 12%.
Suppose there was an initial £100 'arrangement' fee, the total repayment is now £1,220 which pushes the APR to 24.4%.
However, if he repays the loan and interest in equal monthly instalments of £93.33 (£1,120/12) the APR rises to 23.7%! This is because he no longer has the benefit of access to the full £1,120 over the year, it's gradually used to repay the loan.

Inflation

Whereas inflation is bad news for savers, it's great news if you're a borrower. If prices rise over the period you've borrowed money, when you eventually pay it back it'll be worth less in 'real' terms, i.e. in today's money.

Candid Example Ms Power takes out an interest-only £200,000 mortgage over 20 years. If annual inflation over that period is 3% then after 20 years her £200,000 debt would be equivalent to only £108,759 in today's money.

The British Government is probably hoping for some high inflation. Following its recent borrowing frenzy (during the banking crisis etc.), high inflation could significantly reduce the amount the Government has to eventually pay back to its lenders (primarily gilt owners) in real terms.


Secured and unsecured

Secured LoansUnsecured Loans

Borrowings that require you to put up something you own, e.g. your home, as a guarantee you'll repay the loan are called 'secured' loans. If you're unable to repay the lender can take (i.e. 'repossess') whatever you offered as security. With the exception of a mortgage, which are almost always secured against the property you're borrowing the money to buy, secured loans are best avoided.

Secured loans also tend to have variable rather than fixed interest rates, leaving you at the mercy of the lender should they decide to hike rates.


Credit scoring

Before someone lends you money they would want to know the likelihood you'll pay the interest instalments and eventually repay the money. The more risky they believe you are the more interest they'll demand, to the point they'll refuse to lend because they don't think they'll get their money back.

Most lenders use a system called credit scoring to help them make these decisions. To do this they build 'scoring' formulas using information from several sources:

  • Your application form - usually contains details of your income, family and whether you own a home.
  • Previous dealings with the company - the lender could examine past dealings if you've been a customer of theirs before.
  • Credit reference agencies - such as Experian, Equifax and CallCredit collect information from the electoral roll, court records (e.g. country court judgements) and financial data, such as whether you've missed payments in the past, from a large number of banks, credit card providers and other financial companies.

By law you can examine your credit file with credit reference agencies, they currently charge £2 to do so. The simplest way to request this is online: CallCredit, Equifax, Experian.

Bear in mind that credit scoring isn't just used to identify whether you might have problems repaying a debt. Lenders also use it to determine how profitable you might be to them. They would much rather you pay lots of interest for a long time than pay off the loan or balance quickly with minimal or no interest. This means you could get turned down for credit not because your credit risk is high, but because your credit risk is too low to make you a profitable customer.


How much can I borrow?

Your question should really be how much can I afford to borrow? The answer will depend on how much spare monthly income you have and the rate at which you borrow. Don't take out a credit or store card thinking you can get by making the minimum monthly payments, the interest on the remaining balance could soar and eventually overwhelm you.


Pay off debts before you save

Because lenders such as banks and building societies profit by lending you money at a higher interest rate than they'll pay you on your savings, you're almost always better off repaying debts before saving money.


Help with debt

If you're struggling with debts the worst thing you can do is bury your head in the sand. Doing so could mean the debts spiralling out of control.

A few simple steps could help you get back on course, or at least stop you from losing your home or going to prison.

  1. Take a hard look at how much you can spare each month to pay off debts, cutting expenditure on everything else to the bone.
  2. Separate debts into high priority and lower priority - high priority being those where the penalty for not repaying is severe, e.g. mortgages, taxes and payments ordered by courts.
  3. Talk to your creditors (those you owe money too), starting with the high priority, giving them an honest account of your situation and offer to pay off the debt in a way you can afford.
  4. Don't ignore lower priority creditors even though there may be nothing you can do right now to pay back the money. Be realistic as to the prospects of them getting their money back.

You may find lenders of unsecured loans willing to accept payment of a proportion of your debt in full settlement, i.e. they'd rather get something back than nothing at all. If you're really struggling, don't be afraid to try and negotiate.

There are some excellent sources of free, independent advice on debt problems, including: Citizen's Advice Bureau, National Debtline and the Consumer Credit Counselling Service.


Bankruptcy, Individual Voluntary Agreements (IVAs) & Debt Relief Orders (DROs)

If you get to the point where you're drowning in debt with little prospect of being able to pay it off, you might need to consider bankruptcy, an individual voluntary agreement (IVA) or a debt relief order (DRO).

DROsIVAsBankruptcy

If you have debts of £15,000 or less that you really can't afford to pay off then a DRO can help discharge them after 12 months. To qualify your total assets must not exceed £300 (plus up to £1,000 for a car) and your monthly disposable income (after rent and other expenses) must be no more than £50.

Applications must be made through an approved debt adviser and you'll need to pay a non-refundable £90 fee. If accepted a 12 month 'moratorium' period will be placed on the debts meaning the creditors cannot pursue you during this period. After this period the debts will be discharged unless your circumstances improve sufficiently to make payments to creditors.

To apply for a DRO you should contact an approved debt adviser such as the Citizen's Advice Bureau. THey wll check you're eligible and help you complete the application, you'll need to pay a £90 fee. While you can pay the fee in instalments over six months, the application won't commence until the fee is paid in full.

Once your DRO has been approved, creditors will be unable to pursue you for a 'moratorium' period, usually 12 months. At the end of that period the debts will normally be discharged unless your fortunes have improved, allowing you to repay some money to creditors. As with bankruptcy, once discharged you're released from the debts and can start afresh.

Pros Cons
  • An approved debt adviser will help you complete the application process.
  • It's far cheaper than IVAs and bankruptcy.
  • Once discharged, you leave the debts behind and can get on with your life.
  • You can only apply if your assets are £300 or less, i.e. you own almost nothing.
  • You'll remain liable for any court fines, child maintenance payments and student loans.
  • If you wish to obtain credit of £500 or more you must tell the lender you're subject to a DRO.
  • It will affect your credit record and stay on file for 6 years, making it more difficult to open a bank account or obtain credit.
  • You can't set up a limited company without the court's permission.

You'll need to see an insolvency practitioner to set up an IVA. They'll draw up an affordable plan for you to pay back a proportion of your debts and send this to your creditors. Provided at least 75% (by value of your debts) of your creditors agree to it the IVA becomes a legally binding contract. You must then make the agreed payments and your creditors agree to freeze interest and not to chase the debt. At the end of the agreed period, usually five years, the creditors write off any remaining balance so the debt is history.

However, this comes at a steep price. Insolvency practitioners typically charge an upfront fee of £2,500 and an annual fee of £1,000, i.e. £7,500 in total. Chances are you won't pay these fees directly, they'll be funded out of your monthly payments, so make sure you're aware of exactly what you're paying and how.

If you miss any payments the agreement could be void and you may face bankruptcy, so an IVA is not a 'light' option. You may also be expected to hand over any savings and release equity in your home

Pros Cons
  • Your debts are clear after you complete an IVA.
  • You're less likely to lose your home compared to bankruptcy.
  • Creditors might agree to accept less than half the debt as final settlement.
  • Creditors must freeze interest and stop contacting you.
  • You can continue to run a business or work in professions prohibited under bankruptcy.
  • You're locked into making payments for five years, bankruptcy lasts a year and you're not locked into payments.
  • If you earn more or come into cash during the IVA period you could have to pay more.
  • You cannot take out any further unsecured debt during the IVA.
  • Expect to pay fees of around £7,500 over the five years.
  • Expect to hand over any savings and mortgage-linked endowments you may own.
  • You mat lose equity in your home.
  • Credit could be hard to obtain for at least one year following the end of the IVA.

Either you (voluntary) or a creditor (involuntary) can apply to a court for you to be declared bankrupt. After completing application forms, paying fees of around £500, possibly attending court and completing yet more paperwork you can be declared bankrupt, a status that usually lasts for up to a year. An 'Official Receiver' or insolvency practitioner will then take control of and sell your property and possessions (they'll act as 'trustee') to ensure that all those you owe money to get their fair share. If you have an income above your basic living costs, or come into money during your period of bankruptcy, you may be required to pay this to creditors too.

While you're bankrupt you can't borrow more than £500 without telling the lender you're bankrupt or be involved directly, or indirectly in the setting up and/or running of a company.

When you're discharged from bankruptcy, normally after a year or less, you're released from the debts and can start afresh.

Pros Cons
  • Once an order is made a third party will deal with the administration, decision making and payment process of the debts.
  • You'll usually pay less via bankruptcy than with an IVA.
  • Once discharged, you leave the debts behind and can get on with your life.
  • You could lose any assets of real value including your home, business, life insurance and possibly pensions.
  • It can prove expensive as all fees, including a 15% levy on sums received by the 'trustee', are deducted from your assets.
  • Certain debts cannot be written off, including: fines, maintenance/child support payments, debts to secured creditors.
  • Your name will appear in the London Gazette, in a local paper and on the Insolvency Service website.
  • Credit could be hard to obtain for at least six years following bankruptcy.

Jargon

Here's some of the more common borrowing jargon you might come across:

JargonMeaning
Affinity CardA credit card that donates to a charity/football club etc when you spend money. A good deal for the charity, but usually a bad deal for the customer.
APRAnnual Percentage Rate. Shows the overall cost of a loan, taking into account the term, interest rate and other costs.
Authorised OverdraftWhen your bank account has a negative balance, with the bank's permission. Terms are usually favourable compared to an unauthorised overdraft.
Balance TransferWhen you transfer an outstanding balance from one credit card to another, perhaps to benefit from a lower rate.
Booking FeeA fee charged by many mortgage lenders when you apply for a mortgage. Common, as it helps them make their interest rate look more attractive.
Bridging LoanA bank loan enabling you to buy a property before selling your existing home.
BufferAn agreed amount above your authorised overdraft into which you can slip without the usual penalties applying.
CapThe maximum interest rate above which your mortgage cannot go.
Card IssuerThe bank, building society or store whose name is on your card.
Cashback CardCredit cards that give you a percentage of the money you spend (e.g. 1%) as a cashback.
Chip & PinCredit card security system that replaced signatures. Combines a small electronic chip built into the credit card with a four digit number entry at the point of purchase.
CollarThe minimum interest rate below which your mortgage cannot go.
Credit LimitThe maximum amount you may owe through spending on the card. Exceeding this could incur charges and the card being suspended.
Credit ScoringA method lenders use to assess how likely a person is to repay the money they wish to borrow.
Discounted MortgageA mortgage that offers a discount on the lender's SVR or a tracker rate, usually for up to three years.
Fixed Rate MortgageA mortgage whose interest rate is fixed for a period of time, usually up to five years.
Flat InterestAn interest rate that is charged on the original sum borrowed throughout the term. To get a rough estimate of the APR, double the figure.
GAP InsuranceGuaranteed asset protection insurance is designed to make up any shortfall between what's owed on hire purchase and a car insurer's payout if your car is written off or stolen.
Hire PurchaseSimilar to a loan, except the goods purchased do not belong to you until the loan is fully repaid.
In ArrearsDescribes a debt when you've failed to keep up the monthly repayments.
Interest Only MortgageA mortgage where your monthly payments are used to pay interest only. The amount borrowed will still be outstanding at the end of the mortgage term.
Interest-Free PeriodThe time between when you buy something on the card and the date when you must pay your monthly bill. Can be up to 56 days.
Lease PurchaseAnother name for hire purchase, usually applied to car policies.
Minimum Payment The minimum amount you must pay each month to avoid charges in addition to interest.
MortgageA type of loan used to purchase a property. It will normally run for 20 - 25 years and be secured against the property being purchased.
Mortgage Indemnity GuaranteeAn insurance designed to protect mortgage lenders if they repossess your home and are left out of pocket when the property is then sold.
Negative EquityThe difference between your home's value and your mortgage when the home is worth less than the mortgage.
Offset MortgageA mortgage that is linked to a bank account, with any savings offsetting the balance owed, hence interest payable, on the mortgage.
OverdraftA temporary loan that kicks in should the balance on your bank account fall below zero.
PCPsPersonal contract plans, a type of hire purchase where you must pay a large final payment to keep the goods (e.g. car) else hand it back to the finance company.
Redemption PenaltyA charge applied by some mortgage lenders if you want to repay your mortgage early.
Re-MortgagingSwitching from your current mortgage to another.
Repayment MortgageA mortgage where your monthly payments are used to pay interest and repay the outstanding balance.
Rewards CardCredit cards that give you some sort of reward (e.g. air miles) when you spend money.
Secured LoanA loan where you have to offer the lender security (e.g. your home) in case you can't keep up payments.
Student LoanA government loan for qualifying students, offers a subsidised rate of interest linked to the rate of inflation (RPI).
SVRStandard variable rate. A mortgage lender's plain vanilla mortgage rate, usually a few percent above the Bank of England Base Rate.
Tracker MortgageA mortgage whose interest rate is variable and follows the Bank of England Base Rate exactly, usually by a fixed amount above or below.
Unauthorised OverdraftWhen your bank account has a negative balance, without the bank's permission. This can result in stiff charges and high interest.
Unsecured LoanA loan where you don't have to offer the lender security (e.g. your home) in case you can't keep up payments.
Valuation FeeMost mortgage lenders charge you to carry out a valuation, making sure the house is worth at least what they're lending you.