Five Ways To Cut The Cost Of Debt

With personal debt tripling in just eleven years, we really need to manage our borrowing better. Here are five tips to get started.

When borrowing money, perhaps the most important piece of information is how much interest you will pay for the privilege. Of course, the less interest you pay, the more of your money you hang onto, so it makes sense to minimise your interest bill. How much interest you'll pay depends on five variables:

The advance (how much you need to borrow);
The interest rate charged (usually expressed as the annual percentage rate, or APR);
The fees charged by the lender;
The length of time over which the debt is repaid; and
The frequency of your repayments.

It's easy to see how these variables work. If your advance is higher, so too will be your interest bill. Likewise, higher interest rates and fees bump up your bill. On the other hand, by making payments more often or taking out a loan over a shorter period, you can prune your interest bill.

By considering the relationship between credit and time, we can devise many ways to reduce the ongoing cost of a debt, such as a mortgage, personal loan, credit card or overdraft. Here are five ideas to start you off:

1. Borrow less

Lenders often tempt you into borrowing more than you actually need. Indeed, I recall one loan advert which urged applicants to "borrow a little extra to treat yourself". Larger loans mean bigger profits for banks, so it makes sense to borrow as little as you can. So, if you need, say, £5,650, don't be tempted to round up your loan to £6,000!

2. Reduce the interest rate

Of course, the lower the interest rate, the cheaper the debt -- all other things being equal. So, do pay attention to the interest rate and fees being charged. However, don't be duped by the headline APR, as this can be misleading. Always check the small print to see exactly how much you'll pay in interest and fees -- and never sign on the dotted line until you have a precise picture of the true cost of a debt.

3. Transfer your debt

One way to cut the interest rate you're paying is to transfer existing debts to a new home. For example, by transferring credit-card balances to a 0% balance transfer card, you can freeze your interest bill for a year or more. The clear winner in this category is the Virgin Money MasterCard, which charges no interest on transferred debts for sixteen months, on payment of a 2.98% transfer fee.

Another option is to `roll up' existing debts into a single debt, usually in the form of an unsecured personal loan or secured loan (second mortgage). Unlike Carol Vorderman, I would urge you not to go down this route. Consolidating your debts may produce `one easy monthly repayment', but it could raise your total interest bill. Even worse, secured loans could threaten the roof over your head, so give them the bargepole treatment.

4. Make more frequent repayments

By paying more frequently, you chip away at your debt faster and, therefore, bring down its cost. For example, millions of American homeowners prefer to pay their mortgage fortnightly, instead of monthly. By making 26 payments of half the usual monthly mortgage repayment, they make thirteen monthly repayments per year, instead of twelve.

However, if you want to change the amount or frequency of your mortgage repayments, please do check with your lender before going ahead. Otherwise, you could be in breach of your mortgage agreement!

5. Repay over a shorter period

Why take out a personal loan or other credit agreement over, say, five years if you can comfortably afford to repay it in four? Time is always a function of credit, because the shorter the time period, the lower the interest bill. Hence, aim for the shortest term (life) for your loan, while making sure that your monthly repayments aren't too high.

Finally, to check the total cost of a debt, always look for the TAR -- the total amount repayable. This shows the overall cost of credit, including the advance and interest, plus any fees. TAR for listening!

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