Learning to play the debt game

Debt counsellors are warning that years of low interest rates have tempted people into dangerous levels of borrowing and created a generation unable to budget.

'It's not how much you owe, it's whether you can afford to repay it,' says Meg van Rooyen, information officer at National Debtline. 'It's impossible to define a safe level of debt because your ability to cope can be affected by a life crisis such as sudden illness, divorce, redundancy, loss of overtime, childbirth or disability. We see people who had been managing their borrowings but then took on one loan too many, or some personal crisis tipped the balance the wrong way.'

Interest rates have been so low for so long that people have become accustomed to cheap debt. Now that there are signs that they may rise in the medium term, it becomes particularly important to make sure you can manage your commitments.

Carl Bayliss, manager of National Debtline, says: 'Even people with standard variable-rate mortgages have not seen much of a change in their monthly payments. When interest rates do start increasing - and they eventually will - people who are just about managing to cope with their debt could quickly start to have difficulties.'

Just 4 per cent of the callers to the charity's helpline are over 65, perhaps because the older generation grew up without the pervasive culture of easy credit. Those most at risk of defaulting on their payments are aged between 20 and 30. They make up 40 per cent of the total, and some have debts of between £50,000 and £100,000.

'Debt has become such a part of everyday life that it has become socially acceptable,' says Bayliss. 'There is a fine balance between managing your borrowings and having uncontrollable debt.'

The key is making sure you are in control. 'When we are advising clients we ask about their debt levels,' says Roderic Rennison, group financial services director of Bradford & Bingley, which owns the adviser Charcol. 'People haven't really thought much about this. If you are repaying debt at an interest rate of 4.5 per cent now, how would you cope if rates went up 2 percentage points?'

But if you know how to make debt work for you, it can be an efficient way to buy a house, fund a holiday or buy a new sofa. To play the debt game, you need to know how the charges work.

Credit cards

Most standard credit cards are free, though you may have to pay an annual fee for a platinum or black card - for example, HSBC's Platinum Visa costs £30.

Beware charges for late payment, for exceeding your personal limit, or unpaid direct debits (usually £20 for each offence.)

When you pay off your balance, the credit card company will use the money to pay your debts in a set order. 'This differs from company to company,' says Samantha Owens, senior researcher at Moneyfacts, the independent money advice company. 'You should be able to find out by looking at the back of your monthly statement or by ringing up your credit card company.'

For example, on the AA credit card the order is fees and interest rates first, then cash advances and balance transfers. With most providers, if you use your card to withdraw cash you will be charged a higher APR than on retail purchases and pay interest immediately.

Transferring balances

One smart way to use debt is to transfer your outstanding balance to a card charging zero per cent for an introductory period. You could pay off your debt or switch whatever remains at the end of the special period to another zero percent card.

Owens says: 'If you opt for a six-month offer of 0 per cent interest it is possible to transfer your balance to another card at the end of the introductory period. There is no obligation to pay off your balance, so you could keep transferring it.' Financial data service Moneyfacts recommends taking out a zero per cent card in time for Christmas. RBS Advanta is offering a card charging zero per cent over nine months on purchases as well as debt transfers.

However, you need to watch out for transfer fees. Card providers won't usually charge you for transferring balances during the 0 per cent introductory period, but will slap on a fee once that expires. Barclaycard levies a minimum 2 per cent of the balance transfer, with a minimum fee of £2. Abbey National also charges 2 per cent of the transaction value, capped at £35.

Morag Fleming, spokeswoman for Abbey National, says: 'There is no limit on the number of transfers you can make during the six-month introductory period, but then we do charge a handling fee after that.'

Even with this charge, you would be saving money if you had a large debt which you transferred from a store card with a high APR to a credit card with a lower rate. For example, the Monsoon and Laura Ashley cards have an APR of 30.7 per cent, compared to Abbey National's rate of 15.9 per cent. You would be even better off if you switched to a card with a long-term low APR rate such as Cahoot, at 8 per cent.

Interest rates

Some credit card companies charge from the statement date, or the day the item was purchased, or when it hits your account. If you don't pay your balance off in full each month, interest will be backdated. Check how long your interest-free period is - you get 59 days from Abbey National, Britannia, and Halifax, but only 45 from Egg and 46 from Cahoot.

Offset mortgages

These combine mortgage, personal loan, savings and current account, putting all your savings in one place and offsetting them against all your debt. Rather than earning interest, your savings reduce the interest you pay on your mortgage, loan or credit card. If you are a taxpayer, it's an effective way of making your money work harder. If you run your own business, it is a useful way of managing cashflow - you can overpay during good times and take payment holidays during bad.

Personal loans

'Beware of loans secured against your home because you don't want to be repossessed if you default on your payments,' says van Rooyen of National Debtline.

If you do want a personal loan, consider an unsecured loan and be wary of repayment penalties. Mike Naylor, senior researcher at the Consumers Association, says: 'Personal loans may seem attractive because repayment is spread over a long period and monthly premiums are lower. This means, however, that you pay more in interest over the long run.'

Paying a loan off early may also attract redemption penalties, which could be six months' interest. Intelligent Finance and Egg don't have redemption fees.

Ship-shape
An astute combination of consolidating his personal loan and overpaying on his mortgage means that when Lieutenant Mike Penfold leaves the navy next year his finances will be thoroughly ship-shape.

The 46-year-old took out an interest-only offset mortgage with First Direct in May 2002, which he is using to repay a personal loan of £8,000.

The mortgage is interest-only, so he is using any spare money he has to overpay each month and to make contributions towards an endowment policy to pay off the capital of the loan.

Penfold, who is based in HMS Collingwood at Fareham, began his career 20 years ago and now trains young officers.

'I will be leaving next year and I want to get my finances in order in case I have to take a wage drop,' he says.

'In my spare time I earn money as a football referee and I use one of the savings accounts from First Direct to accumulate money to pay my tax bill at the end of the year.

He adds: 'Since this is also offset against my mortgage I effectively earn around 4.5 per cent on my savings without having to pay 40 per cent tax on the interest that I earn.'

'I'm on top of my cashflow with a flexible mortgage'
Simon Reynolds, 39, runs a new media company with his business partner Graham Hughes, and uses a combination of different bank accounts to manage his cashflow.

His company, Evoke Digital Media, sells products to companies including Experian, Virgin and B&Q.

He says: 'I have three bank accounts and a flexible mortgage from Intelligent Finance which I use to manage my money. Some months we earn nothing because we are working on sales and research, while at other times we receive large sums of money in payment.

'Having an offset mortgage means that I can move the money around online to pay off credit-card bills, personal loans or direct debits. It works brilliantly for someone like me who has unpredictable sums coming it and allows me to manage my debt efficiently.'