FOOL'S EYE VIEW

Why Success Breeds Debt

By Neil Faulkner (TMFVertigo)
April 27, 2006

The last company I worked for was wealthy and successful, so it could afford to treat its staff well. (Er, just like The Motley Fool, of course.) We were relatively pampered compared to the real world, as I often would remind my former colleagues, many of whom seemed to have little understanding of personal finance and live beyond their means. I suspect it's something to do with the pampering. They've developed a taste for luxuries that can only come from working in the top place on the Monopoly board. They live Mayfair lifestyles on Vine Street salaries.

However, after further conversations I found that most of them didn't arrive in Mayfair with a clean bill of wealth. Despite increasing financial success, their debts have grown steadily over the years. This is not a story confined to the dark blue squares, or even just to London. It's one many of you will be familiar with...

Your early twenties

You're a year into your first job and you've been reaping the benefits of financial independence. Big companies have been fighting to give you money. You've just got a credit card and straight away you've bought loads of gadgets and clothes, all with money you haven't even earned yet. Now that's beating the system!

You drink lots of booze and go on a long holiday but it's OK, you can pay by credit card. You're paying £100 a month to reduce your debts quickly. At first it was interest free on a 0% card, but that deal's expired. Come to think of it, the debts aren't going down any where nearly as fast now, because of the interest.

Late twenties

And still companies throw money at you and you've now got two or three credit cards and a loan. You go on another long holiday and you buy a new car. The insurance costs a lot, but you can pay for it with a credit card and worry about the bill later.

Then you get your first bonus. You saw it coming, because your more experienced colleagues told you what you'd get months ago. You were going to pay off your debts with it, but you've got an awful lot of social plans this month and next. Thinking: "What difference does it make if I spend the bonus now or in a few months?" you decide not to wait.

But then the bonus comes and you go out with all your colleagues, blowing loads of it on one fantastic night out. They're all planning to buy new clothes, TVs, sound systems and makeovers with the remainder. You think to yourself: "I should do that. Besides, I can live with my new level of debt, that's not a problem. There's always next year's bonus." So you're now comfortable with the fact that your debts have gone up by twice your bonus in a just few months.

This may happen for a few years, but as long as the credit card companies are supplying you with money, you can afford the £250 to £300 a month debt repayments, even on top of your rent and rapidly increasing energy and council tax bills.

Early thirties

In a New Year's resolution, you decide you need to start earning more money to pay for your increased debts, so you get a better job. Your card bounces in a restaurant, not for the first time, but it's particularly embarrassing because you've just proposed to your partner who's sitting opposite you. Thankfully he or she has already said 'Yes', so there's no backing out now.

...You can't believe how much that marriage cost! Both of you are in a similar financial position. You've each built up thousands of pounds in debt that require repayments of £400 per month each. What's more, nearly all of what you pay is interest, so your debts hardly seem to go down at all. You don't know what to do about it, until one of you says: "Hang on! Let's get a house. If we take out a mortgage we can extend it to cover all our debts more cheaply."

So that's what you do. Now you have a flexiloan with nothing in it and six to ten credit cards between you, all empty. All that 'free' money just begging to be spent. "We need a bigger car for our first child and double glazing to keep the baby warm. We've got £200,000 of debt with the mortgage already; it can't hurt to take on a little more debt. Can it?"

How to reverse the damage your success has caused

If you're lucky enough to read this before you've got your first credit card, then I hope you've taken on board the way that this can go. Unfortunately, most of you already have personal loan and credit card debts. I hope that this pattern hasn't continued on from your thirties but, wherever you are in this cycle, here are some options to reverse the damage your success has caused.

Personal loans

Personal loans aren't the cheapest way to borrow, but they are suitable for people who can't stop spending. It's relatively difficult to increase loan debt and easier to get into the habit of reducing it. This is firstly because most loans aren't flexible, so it takes effort for you to increase the amount you borrow. Secondly, you don't carry around loan cards, so you can't easily use a loan for impulse purchases like you do when you have credit cards.

Furthermore, personal loan rates are excellent at the moment at sub-6%.

Credit cards with fixed rates for life

Another way to borrow is using credit cards with fixed rates for life. This is suitable for people with greater willpower in the shops. It's also for any of you who want to easily be able to make extra payments to reduce your debt, without incurring early repayment penalties (which you get with most of the cheapest personal loans).

Like personal loans, these cards are cheap right now, with the best rates below 6%. I like the fact that balance transfers you make to them in the first month or so have a fixed rate. However, if your willpower breaks and you add balances to it later, you'll probably suffer from much worse rates until the whole balance is paid off.

Borrow from individuals

You might want to be more radical and try Zopa, which is a relatively new way to borrow money. The lenders are individuals like you and I, so this is suitable for people who are fed up with giving loads of their monthly income to big greedy businesses. Zopa is very competitive; you can get comparable or even better deals than you get with personal loans or fixed-rate credit cards.

How it works is individuals lend £500 to £25,000, but they only lend £200 to each borrower, so the risk is spread between lots of lenders.

0% credit cards

Perhaps the best way to reduce debt is by using 0% credit cards. What you do is you get a card offering 0% on balance transfers and transfer your debts to it. About a month before the introductory 0% period expires, you apply for another 0% card and transfer your balance to the new one.

Alas this isn't usually free, as most providers charge a 2% fee on your transfers (with many capping at £50). However, it's still the cheapest way to borrow of all these options. This method is only suitable for people who are disciplined enough to keep switching cards before the deal expires and who don't spend any more money! (Be wary about making purchases on 0% balance transfer cards. See this article for more details.)

Lastly, as soon as you switch, tear up your now cleared credit cards and close all other loans, or you'll just use them to build up more debts. And use your success to reduce your debts: pay them off with your raises and bonuses. I promise it'll be worth it.

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