Fool's Eye View

[ October 27, 2000 ]

Borrowing Money

By Nigel Roberts (TMFNigel)

Chippenham, Wiltshire -- All true Fools will know that just about the most important thing that you can do when starting to sort your finances is to pay off all of your debts (apart from perhaps your mortgage), and to pay them off as quickly as possible. This cornerstone of Foolish philosophy is ingrained deep into the psyche of Fools, so much so that it is very easy to forget that most people in the UK carry quite significant amounts of debt over from one month to the next on credit cards or overdrafts.

Carrying debt is most definitely a bad thing to do. But if you are going to do a bad thing, then at least do it in as Foolish a manner as possible and make sure it is the least bad thing that you can do!

Credit Card Debt

It may not seem to be such big deal if you have a balance on your credit card at the end of the month, and decide, just this once, to only pay off the minimum amount required. But remember, most credit cards charge extortionately high rates of interest. In the UK we carry about 45 million credit cards, on which we owe an average of £1,600. My own credit card company would charge me 1.488% per month if I did not pay off the balance in full every month. This means that on the average credit card debt of £1,600 I would be paying £23.81 in interest each month. If I just paid off £100 each month, but added another £100 in spending on the card each month, the debt that I would owe would increase by £23.81 the first month, and even more in subsequent months as the debt would rise. After one year the amount I would owe would have increased to £1910.28, an extra £310.28, or equivalent to an interest rate of 19.4%.

Now if I know that I will regularly carry credit card debt (which we know is very unFoolish), then the most Foolish thing to do is to make sure that I carry this debt on the card that charges the lowest rate of interest. I spent a little while surfing the net today, and found very quickly that Cahoot (part of Abbey National (LSE: ANL)) offers a credit card with an interest rate of just 8% per annum, a rate most of us would have been happy to pay on our mortgages just a few years ago. If you are the "average" person described above, using a Cahoot credit card in the unFoolish manner described would cost you £128 in interest, a saving of over £182 compared to what I would pay to my current credit card company for the same debt. If you're going to do a bad thing, make sure you do the least bad thing possible. Shopping around pays off.

Overdraft debt

Many people find themselves dipping into the red at the end of the month, and end up being charged interest on their overdrafts. Overdraft debt is not Foolish, but as we have said before, even Fools sometimes behave in a -- small f -- foolish way. The most important thing is to never, ever let your bank balance slip into the red without already having arranged an overdraft with your bank. Unauthorised overdraft rates are even more extortionate than credit card rates, and you are likely to find many other charges are piled on top too.

Looking at my own high street bank, if I arranged an overdraft they would charge me a rate of 1.45% per month, or an annual rate of 18.9%. If simply let my bank account slip into the red without setting up an overdraft then they would charge me 2.2% per month, or a massive 29.8% per year. And remember, these unauthorised overdraft rates do not take into account any additional charges like arrangement fees, securities charges and monthly fees. Overdraft rates don't tell the whole story. Most banks and building societies add monthly fees while you're in the red. On unauthorised overdrafts, First Direct charges a hefty £35 a month and Royal Bank of Scotland £15 a month plus transaction charges. The Lloyds TSB Classic account charges £10 a month and then a further £10 fee each time your overdraft increases by £10 or more.

Borrowing money using an overdraft is just not Foolish, but again: if you're going to do a bad thing, make sure you do the least bad thing possible. If you know that you are likely to carry an overdraft on a your current account, make sure you swap your account to a bank that offers you the best rates possible.

Looking at Cahoot again, if you apply for a current account you will automatically qualify for an interest and charges free overdraft of £250. If you set up an authorised overdraft, the interest rate charged would be just 8% (and possibly even lower if you were to chose one of the more complicated fee and interest rate options). Remember, though, even with a low rate you don't want to slip into the red by accident; they have an unauthorised overdraft fee of £20 and an unauthorised overdraft rate of 22.9%.

And Finally...

We have said that it is very (small f) foolish to borrow money at all. We urge you to always pay off the credit card at the end of each month, and not to dip into the red on your current account. These are bad things for a Fool to do. But if you are likely to do either of these two things, make sure you are Foolish: prepare for it beforehand and do the least bad thing possible.

But whatever you do, don't commit the biggest Foolish sin of them all. Don't borrow money on your credit card, or on your overdraft, while you have money sat in a savings account somewhere earning pitiful rates of interest. Even if you have taken my advice from the Fool's Eye View of last Friday, and moved your savings to a high interest bearing account paying 7% gross, and you have set up a credit card that cost you only 8% or an overdraft that costs you only 8%, you're still borrowing at a higher rate than you're earning. You would be daft to have savings and be borrowing money at the same time. Remember, too, that any interest you earn on your savings will be taxed, while interest that you pay on your borrowings comes out of your after-tax income.

One more thing: competition is rife in the banking world, rates change often, and the deal that may be best for your this month may not be the best for you in a few months' time. Be prepared to move your money around much more often than you have in the past. It is often said that you are more likely to get divorced than you are to change banks: don't let inertia or apathy allow your existing bank to get away with charging you too much interest on your borrowings, or paying you too little interest on your savings.

Where Next?

• Want more money-saving tips? Visit the Living Below Your Means discussion board.
• Cahoot website -- http://www.cahoot.co.uk/
• Shop around for Savings -- Fool's Eye View from Friday 20th October.
• Online Banking Centre