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CHAPTER 2 Reviewing your overall financial position
Lots of people buy a pension or a unit linked fund without ever thinking about their overall financial position. Savings and Investment decisions cannot be decided in isolation. You must consider your overall financial position before deciding which is the most suitable investment for you.
PAY OFF ANY CREDIT CARDS, CAR LOANS OR OTHER EXPENSIVE BORROWINGS FIRST
There is no point in depositing money at 3% while paying interest at 18%. But it is amazing the number of people who do. If you have a running balance on your Credit Card of £ 1,000 on which you are paying interest, it is costing you £180 a year. If you have £1000 on deposit, you are probably getting about 3% after tax. That means it's costing you £150 a year for which you are getting absolutely nothing. So pay off any expensive loans first.
By the way, if you are paying interest on your credit card on a regular basis, you should cut up your credit card. If you are not good with money, you should not have a credit card.
But I
like to keep some money available for emergencies
People get a sense of comfort in having £1000 in a deposit or current
account "in case of emergencies ". There is no harm in doing
this as long as you don't have expensive borrowings at the same time.
If you pay off your loans and an emergency happens, then the bank will
lend you the money again. But if the £1000 is not in your deposit
account, fewer emergencies might arise. For some people an emergency is
a new outfit for a wedding, a new stereo for the car. You might be less
encouraged to buy these if you realise that you are actually borrowing
to buy them.
BUYING A HOME IS YOUR NEXT PRIORITY
If you already own your own home, you can skip to the next section
If you do not own your own home, you should gear your savings and investment strategy to make it possible for you to buy a home as soon as possible. Owning your own home has many financial and non-financial benefits: The main benefits is that you can make the place your own and do what you want. Once you have the mortgage under control, you will never again have to worry about having a place to live, no matter what happens to you financially. If you don't own your own home, rents can rise and rental property can become scarce. Also you will have no security. So, accumulating the deposit to buy a house takes priority over everything else.
Young people who don't have a home often commit themselves to totally unsuitable savings schemes. For example, they sign up for long term savings schemes which have high initial costs or which have terminal bonuses. They find themselves in a situation 5 years later when they want to buy a house. They go to the life insurance company to find that the £6,000 they have contributed over the last 5 years is now worth only £5,000. They have to cash it anyway because they need the money for a deposit.
While we are on the subject of unsuitable financial products, many young single people buy life insurance which they don't need. It is essential for a married person to have life insurance the money can be better saved for a house if you are young and single. When you buy your house, you will need mortgage protection anyway, so that is the time to take it out. Many people take out a plan which combines life insurance and savings and they get very little benefit from it.
Likewise you should not start a pension until you have bought a house. The whole industry, the entire media and your father will tell you that you cannot start a pension too early. This is nonsense and should be rephrased "you cannot start saving too early". A fat pension is no good to you if you want to buy a house. You cannot get your hands on the pension fund. Save outside a pension fund until you own your own home and then worry about a pension. ( The only exception to this is where your employer will contribute more to your pension, the more you contribute. Microsoft Ireland is an example of this. In this situation, you should contribute as much as possible to your scheme).
If you are fairly close to accumulating a deposit to buy a house, you should put your money in the highest paying deposit account which is currently the Northern Rock, but check Askaboutmoney for the latest update.
If you are not going to be able to afford to buy a house for the next few years, then you should consider putting your savings into a stockmarket based unit linked fund with no initial charges. There is risk in this in that your investment might decline in value and you might be further away than ever from buying a house. But against this, the superior returns from the stockmarket might enable you to buy your house sooner than you had planned. For some people, this is a risk well worth taking. Certainly, if you don't see your self buying a house for the next 5 years, then you should definitely be in a stockmarket based fund. But as you get closer to accumulating the deposit, you should start switching your investment to a deposit. You don't want a stockmarket crash to happen just before you are about to buy your house.
I expect
to buy a house in about 2 years time. You say not to commit yourself to
a long term savings plan, but should I avail of the Government Savings
Incentive Scheme?
This is perhaps the only exception because the 25% bonus is so valuable.
Don't start the scheme until April 2002 so that your entire money is not
tied up in the scheme. At that stage, review the situation. If you are
still planning to buy a house, you will need as much as possible for the
deposit. Just put in the minimum £10 per month for the moment. When
you have bought your house and know your financial position a bit better,
you might be able to increase the contribution.
The way
things are going with house prices, I don't think I will ever be able
to afford a house. Is there anything I can do?
If your financial position doesn't allow you to buy a house in the near
future, you should consider getting on to the housing ladder by buying
a house jointly with one or two of your friends. This is not an ideal
situation, but it's better than renting in a market where there is a long
upward trend in house prices. If you do go down this route, make sure
you have a good legal agreement in place to cover such issues as what
happens when one of you wants to sell your interest.
But are
house prices not heading for a crash ?
No one knows if house prices will go up or down in the short term. But
it is very likely that they will rise over the medium to long term.
If you buy now and house prices do go down, it's a pity but hardly a calamity.
OK, if you had waited you might have been able to get a bigger and better
house. You will be in much more trouble if you don't buy now and house
prices continue to rise. It's quite possible that you will never be able
to afford a house.
TAKE MAXIMUM ADVANTAGE OF THE GOVERNMENT'S SPECIAL SAVINGS INCENTIVE SCHEME
The Government's Special Savings Incentive Scheme is the most attractive investment available. It is more attractive than a pension scheme in most situations. Make sure that before looking at any other form of investment, e.g. contributing to a pension or repaying your mortgage, that you contribute the £200 per month maximum to this scheme. This takes priority over everything else except paying off expensive borrowings. See Chapter for more details on this scheme.
IF YOU OWN A HOUSE, GET YOUR MORTGAGE DOWN TO A COMFORTABLE LEVEL
Most people have to take a huge risk in buying their first home. They borrow the maximum amount often lying to the lender to boost their earnings. In most cases, things work out fine as their salaries increase and house prices increase and the early indigestion of the heavy borrowings eases after a few years. But if the economic environment changes, heavily borrowed people will be in trouble. There are two big risks - a recession affecting their earnings and a rise in interest rates. A fall in house prices is not in itself a problem unless you have to relocate.
So it's very important to concentrate on getting your mortgage down to a comfortable level. What a comfortable level is depends to a great extent on a variety of circumstances e.g. how safe your job is and how the economy is faring. As a rough rule of thumb, try to get your mortgage down to about twice your annual salary or 50% of the value of your house.
Of course, you should take maximum advantage of the Government Special Savings Incentive Scheme and should not increase your repayments on your mortgage until you, and you spouse if appropriate, are paying in £200 a month each.
I have just received a redundancy package of £40,000. Should I invest it or pay off my mortgage?
The current mortgage rate is about 6%. The tax-relief is very small, so let's ignore it for simplicity. Assume also that you have a variable rate mortgage with no redemption fee. If you pay off your mortgage, you will save yourself 6% a year or £2,400. That is real cash into your hands, tax-free. If you leave your monthly repayments as they are, your mortgage will be repaid quicker.
If you put your money in a deposit account, you will probably get about 4% interest from which DIRT of 20% will be deducted. So your £40,000 will earn you £1,300 after tax. So you can earn £1300 deposit interest or save £2400 mortgage interest. The only reason you would do this is if you needed the money for something else in the immediate future. For example, it wouldn't be clever to pay off your mortgage at 6% and then borrow to buy a car in a few months time at 10% !
But can't I invest the £40,000 in the stockmarket and earn more than the 6% mortgage rate?
Let's say you have a mortgage of £100,000 on a house worth £200,000. Would extend your mortgage to £140,000 so that you could invest in the stockmarket ? Most people wouldn't. So if you have a mortgage of £140,00 and you have just received a lump-sum of £40,000 why should you invest it in the stockmarket ? It's the exact same decision looked at from another angle.
It's a good general principle not to borrow to invest in the stockmarket. And investing in the stockmarket while you have a mortgage is effectively borrowing to invest. It's risky. It might pay off handsomely or it might cause you a lot of sleepless nights.
I would recommend
that you should pay off your mortgage with any lump sum, except in the
following circumstances:
You have some experience of investing in the stockmarket already and can
handle its ups and downs
And
Your mortgage is comfortable - i.e. less than 50% of your house value
and less than twice your annual salary
And
Your job is fairly secure
When you weigh up all the above issues, you might decide to pay a bit
off your mortgage and invest the remainder in the stockmarket. I do think
that everyone who can, should have some exposure to the stockmarket, no
matter how small. It's good to get a taste of how the stockmarket outperforms
all other investments in the long term. This will help you to make a decision
in future, if you have more money to invest.
IS YOUR PENSION ADEQUATELY FUNDED?
Contributing to a pension is the most attractive method of savings after the Special Savings Incentive Scheme. The tax advantages are huge. The big disadvantage is that you cannot access your money until you retire. If you can put away money for the long term, you should contribute to a pension scheme.
But don't overdo it. As has been mentioned above, contributing to a pension when you don't own your own home is not good financial planning. Likewise, if your mortgage is uncomfortably high, you might be better off trying to reduce the mortgage first. However, if you are within 20 years of retirement, it can make sense to have a high mortgage while contributing to a pension scheme - this is known as a pension mortgage and is discussed further in Chapter .
I am a self-employed doctor. I don't have a pension as such. I own my own home but am thinking of buying another house to let as an investment. That would be my "pension". Is this sensible?
No it is not sensible. I know a few people who buy property as their pension. The big attraction of a pension is that you get tax relief at your top rate on contributions to your pension. The fund accumulates tax free. And you get 25% of your fund tax-free when you retire.
What you
are doing is buying a house out of after tax income. You pay income tax
on your rent and CGT on any profit you make on the property. The only
attraction of what you are doing is that you can borrow to invest in a
property, whereas it is not usually possible to borrow to invest in a
pension fund. However, borrowing to invest in anything increases the risk
and is probably not a good idea.
LOOK AT YOUR TOTAL WEALTH
If you own a house, it probably accounts for a big proportion of your total wealth. Buying another house as an investment would be a mistake as it is concentrating your investments instead of diversifying them. If property suffers a crash, your total wealth will get hit badly.
If on the other hand, you own a portfolio of shares as well as a house, a crash in house prices might be balanced by a good performance from the shares.
You should only own any particular share as part of an overall portfolio. So if someone asks is eircom a good investment, the answer is that it is only a good investment as part of an overall portfolio of shares. No matter how attractive an investment is, put it in perspective.
You might
prefer to look at your liquid assets separately. For example, many people
ignore their house and pension when looking at their overall wealth. As
investment is a long term strategy, this is not a good idea.