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 reply 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… All mortgage lenders had to adopt much stricter rules in 2014, so if your friend got a mortgage before then, they may know nothing about the current mortgage market.
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?
This is becoming an even larger problem with rising house prices in some parts of the country. 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, are also needing to save more money for a deposit as relying on the equity from their first house isn’t 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 to the deposit / 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;
- put some money away for a deposit each month but overpay your debts as well.
Encouragement to save
The government is offering a large carrot for you to save for a deposit in the form of Help To Buy ISAs. Martin Lewis has summed up Help to Buy ISAs as:
“a no-brainer if you’re a first-time buyer saving for a mortgage deposit. You can earn up to 4% interest tax-free and then the state will add 25% free cash, and it could be £1,000s, on top of what you save.”
You have to save each month, and there is a limit to how much you can save. Full details in the above link which also looks at how the new Lifetime ISAs will work from next April.
With this big incentive on offer, it may feel sound better to start saving in these ISAs as soon as possible rather then repay you debts first, so you can get as much help from the government as possible.
But though 25% sounds big – and it is huge in relation to interest rates you can get on normal savings – it’s important to remember that this isn’t 25% per year, it’s a one off bonus. So you can’t just think “I’ll be better off keeping my credit card balance high as I’m only paying 17% interest on that”, because that is 17% per year.
UPDATE August 2016 Like most people I assumed that Help to Buy ISAs can be used as part of the deposit you put down when you exchange contracts. It turns out they can’t! See Help to Buy ISA Scandal. The details of how this works are explained in point 9 of the MSE guide to Help To Buy. This isn’t a problem for people who can use the Bank of Mum and Dad temporarily, or who weren’t that short of money in the first place. Those would of course be the people that didn’t actually need any help from the government! But is close to useless for people who are actually finding their first house purchase a real struggle.
Debts and mortgage affordabilty
Non-problem debts didn’t used to create difficulty for a mortgage application – providing your credit rating was fine, lenders mainly looked at the size of your deposit and how much you were borrowing in relation to your income.
From 2014, lenders have had to look closely at how affordable the mortgage is for you, not just now but possibly in a few years when interest rates go up. As a result, they now look at all your regular commitments, and that includes credit card repayments, monthly car finance costs and your other debts.
Your plan for the next few years needs to include reducing your debt levels to low levels in relation to your income. If much of your debt is refinanced at 0%, this may not feel like real debt at all to you – but a lender will be worried you may not be able to balance transfer it next time. Also 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 very 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, say credit cards, then 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 any debt costs.
If you have had debt problems in the past, so your credit record has late payments or even defaults, then your aim has to be to show the future mortgage lender that these problems are well in the past.
Option (1) – the one suggested by the friend originally, doesn’t feature here at all. It would be a very bad idea to ignore these defaulted debts.
The sooner you can pay off the problem debts the better. If it is going to be two years until you can get a mortgage, it’s better to clear the debts in the first year so by the time you do apply, your credit record will show old debt problems in the past but a completely clear year. So definitely go for option (2).
This applies even if the defaults are getting old and are just about to drop off your credit file. A mortgage lender is going to want to know about all your debts, even if they aren’t showing on your credit reports any more. They will be able to tell from your bank statements who you are making payments to, so that £10 a month which seems to be keeping the debt collector happy and avoiding any CCJs, will highlight a debt you haven’t settled.
I have written more about how past credit record problems affect your chance of getting a mortgage in Can I get a mortgage with debts?
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 or if you use some of it to repay some 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.
On lower deposits this is a harder call. 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%. 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.