A reader asked: “A friend said not to pay my defaulted debts off but save money towards a deposit for a mortgage – is this a good idea?”
It’s often unwise to rely on friends for debt advice. They may be guessing, their situation may have been quite different from yours, or they may be assuming what happened to them years ago is still useful today… they may know nothing about the current mortgage market.
A common dilemma
This is an important question for many people. If you have debts which you are managing, how do you balance clearing them against saving for a mortgage? And how does this change if you have problem debts?
Rising house prices in some parts of the country make saving a deposit harder. Halifax data shows the average deposit level was over £32,000 for a first time buyer in 2016 – more than double what it was in 2008. And wages haven’t doubled since then :(
Most of the “incentives to save” are aimed at first time buyers – but second steppers, wanting to move to a large family-sized home, also need to save more money as the equity from their first house may not be enough.
The three different approaches
If you are serious about buying a house in a few years, there are basically three approaches you can use for the deposit vs debts problem:
- pay the minimum to the debts and maximise your deposit saving;
- pay off all the debts first then start to save a deposit;
- a bit of both: put some money away for a deposit each month but overpay your debts as well.
Encouragement to save
The government has been offering a large carrot for you to save for a deposit in the form of Help To Buy ISAs. You have to save each month, and there is a limit to how much you can save. In April 2017 a different carrot came: the Lifetime ISAs. Find out if this will be a better option for you:
Lifetime ISA vs Help to Buy ISA – Martin Lewis demystifies the pros and cons. pic.twitter.com/l597IA3v3H
— Money Saving Expert (@MoneySavingExp) March 11, 2017
With these big incentives on offer, it may sound better to start saving in these ISAs as soon as possible rather than repay your debts, so you can maximise the help from the government.
But although 25% sounds big, it’s important to remember that this isn’t 25% per year, it’s a one-off bonus. So don’t think I’ll be better off saving and getting that 25% bonus as I’m only paying 17% interest on my credit card balance” because that is 17% per year every year that you are paying. After two years you will have paid 34% overall in interest to that card.
Debts and mortgage affordability
In 2017, mortgage lenders are looking closely at how affordable a mortgage would be for you, not just now but later if interest rates go up. To do this, they look at all your expenses including credit card repayments, monthly car finance costs and your other debts.
If you have debt at 0%, this may not feel like real debt at all to you. But to a lender, it is something that could become a problem for you in future.
So your plan for the next few years before your mortgage application needs to include cutting your debts to low levels in relation to your income. Think ahead for future credit – 6 months before a mortgage application is not going to be a good time to get a new car on finance or get a loan for a big wedding!
If your debt is all cheap, then you can take this steadily, repaying chunks of the debt each month and also putting money aside each month for a deposit, so option (3).
But if you have expensive debt, it’s going to be better to go for option (2). Repaying the debts as fast as possible will minimise the interest you have to pay, then you can switch to rapid deposit accumulation when you don’t have lower debt payments.
If you have had debt problems – your credit record has late payments or even defaults – your aim is to show the future mortgage lender that these problems are as far in the past as possible.
This means that option (1) – pay as little as possible to the debts and maximise your deposit is a very bad idea. The sooner you can pay off the problem debts the better so go for option (2).
For example, if you want a mortgage in two years time, it’s better to clear the debts in the first year. Then by the time you apply, your credit record will show old debt problems but a whole year with no issues.
This applies even if the defaults are so old they have already dropped off your credit file. A mortgage lender will be able to see who you are making payments to from your bank statements. That £10 a month which is keeping the debt collector happy will highlight a debt you haven’t settled.
The most difficult problems here are where you are still in debt management – see Can I get a mortgage in a DMP? for details.
Should you use some of the deposit to pay off a debt?
So far I’ve been looking at what you should plan to do over the next 2 or 3 years. But what if you are just about to apply for a mortgage… is the application more likely to be accepted with a high deposit and some debt or a lower deposit and less debt?
If you have a very large deposit – perhaps you have just inherited some money – then usually clearing off a lot of debt is a good idea. A lender may not care if your deposit is 21% or 26%, but repaying your car finance is going to save you several hundred a month and the mortgage is going to look much more affordable.
This is a harder call when you have a lower deposit. Some lenders may have some mortgage deals reserved for people with 10% or more deposit – here you could drop from 14% to 11% deposit and still get the mortgage, but couldn’t from 12% to 9%. When your deposit is just 5%, you need to read up about 95% mortgages, which are expensive and have other problems. It’s a good idea to talk to a broker to try to get a feel for what different lenders might prefer at the time you are applying.