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.
And in this case, the friend may know nothing about the current mortgage market.
A common dilemma
This is an important question for many people.
If you have credit cards, car finance or loans which you are repaying without any problems, should you clear them, if this means saving less towards a deposit?
And how does this change if you have problem debts? Or a current mortgage?
Rising house prices make saving a deposit harder. Check out what the average first-time buyer deposit was in your area in 2020.
5% mortgages all but vanished in 2020. In 2021 5% deposit mortgages are back, but you will need a very good credit record to get one.
Deposits in most places are a lot more than double what they were ten years ago. But your wages haven’t doubled. And of course rents have gone up as well, making it harder to get out of debt and to save a house deposit.
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.
LISAs – a big 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 and the newer Lifetime ISAs (LISAs).
From 2019, you can no longer open a Help To Buy ISA. But if you are aged 18-39 you can start a LISA. See MSE’s guide to how these work.
A LISA offers you a 25% bonus on the money you have added to the account that year.
With that big incentive on offer, it may sound better to start saving 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% every year – it is only on the new money you have added in that year. It is really a one-off bonus – the government is not paying you 25% interest on all your savings over several years.
So it’s wrong to 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.
You can choose between keeping your LISA money in cash or investing it in the stockmarket. If you will need that cash for a house deposit in the next few years it’s usually better to opt for cash, despite the very low-interest rate, rather than take a gamble with this money. If you are using your LISA saving up money for a pension that you won’t need for more than 10 years, then investments make sense as drops in the stock market are more likely to get evened out in the long run.
Debts and mortgage affordability
In 2021, 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 a problem to you. But to a lender, it is a real debt and they won’t assume you will always be able to get a new 0% deal when this one ends.
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. Plan 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. That £10 a month which is keeping the debt collector happy will be viewed as a problem by a mortgage lender who will see it on your bank statements.
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 15% or more deposit. Here you could drop from 19% to 16% deposit and still get the mortgage, but couldn’t from 16% to 13%. The lower your deposit, the more expensive the mortgage is and the better your credit record needs to be.
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.
If you already have a mortgage – overpay that or save in cash?
Most of the “incentives to save” such as LISAs are aimed at first time buyers. But “second steppers” – people 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.
If this is you, all the above applies if you have a lot of other debt.
But if you have very little debt and you can save money every month, you may be wondering if it’s better to overpay your mortgage or to save up the money in a separate account?
A mortgage lender won’t care if you have the money in the bank or a larger amount of equity from the sale of your current house. But it can make some difference to you.
Some of this is psychological – overpaying the mortgage can feel like a painless way to save, you just set up a larger standing order each month, then it happens automatically. And although you can reduce the standing order you can’t be tempted to “dip into” this money.
But having the money in cash gives you extra flexibility. What if you need that cash? In 2020, Coronavirus meant that many people who never expected they would have financial problems suddenly did…