John Ellmore, Director, KnowYourMoney.co.uk
The benefits of taking on a mortgage are clear; from first-time buyers to property investors with extensive portfolios, mortgages enable people to access the property market by taking on long-term debt.
Considering there are 11.1 million mortgages across the country estimated to be worth over £1.3 trillion, it should come as no surprise that mortgage debt is one of the most common forms of debt in UK.
KnowYourMoney.co.uk recently undertook a nationally representative survey of over 2,000 Britons to find out just how many are in debt and how they are managing their finances. The research found that almost one in four (24%) people has mortgage debt; the second most common form of debt behind credit card payments.
This is not a negative, of course; if accrued responsibly, mortgages are an extremely valuable financial instrument in helping people jump on and move up the property ladder. It also gives people access to an asset that can offer significant long-term capital growth. So, to ensure people are able to manage mortgages responsibly, there is some useful advice to keep in mind.
The importance of planning
The long-term nature of mortgage repayments can be a significant financial burden to bear for those who are not on top of their finances. The consequences can also be severe – estimates suggest that across the UK, 61 mortgage possession claims are made every day as a result of borrowers being unable to keep up with repayments.
Careful planning is therefore at the heart of accruing mortgage debt responsibly. However, the aforementioned KnowYourMoney.co.uk survey offered some very telling truths about the way Britons are currently managing their finances and planning for the future.
Perhaps most concerning of all was the finding that two thirds (67%) of those in debt have no money in savings to help pay off urgent debts. Furthermore, 29% of people say they do not feel in control of their debt and have no clear plan of how they will pay it off.
Without clear plans or savings, people’s debts are evidently a cause for anguish – 24% of people in debt say they lose sleep because of it. In order to effectively handle large debts like mortgages, it’s important not to overlook the basics of preparation. Identifying what proportion of household income can be used for repayments is an ideal place to start, as well as realistically contemplating future scenarios that could bring added financial costs.
Lenders will, of course, conduct due diligence as part of the mortgage application process, but they will not have access to the level of detail required to really understand how a mortgage will affect the borrower in the long-term. That’s why a realistic understanding of one’s own personal finances is vital.
The importance of your debt-to-income ratio
There are plenty of financial tools currently out there to help people understand and manage their debt, but you might be surprised to hear that most people are none the wiser when it comes to understanding how to use these tools.
Take, for example, an online debt-to-income calculator. For those who are unaware of what their debt-to-income (DTI) ratio is, you’re not alone. According to KnowYourMoney.co.uk’s research, 44% of UK adults do not know what theirs is, while 39% admit to not even understanding the term.
Put simply, a person’s DTI ratio offers an indication of how much debt they have in relation to their earnings; it is calculated by dividing total recurring debt by gross monthly income.
Online calculators offer a quick and simple way to find out how much debt a person can realistically handle, and can help them inform their decision when choosing a mortgage which suits their individual needs. More generally, understanding your DTI as new debt is accrued and paid off is good practice for those seeking to stay on top of their finances.
Good debt versus bad debt
Further to establishing how much mortgage debt you can take on, accruing debt responsibly also entails knowing the difference between good and bad debt.
Ideally, borrowers should only look to take on good debt. That is, debt which represents a sensible investment in their financial future, leaving them better off in the long-term. Crucially, good debt should not have negative repercussions on a borrower’s overall financial position. In other words, it should not eat into other necessary expenditures such as daily living costs.
Bad debt, on the other hand, will lend itself to financial trouble down the line. Examples of bad debts are those which cannot realistically be repaid, or provide no tangible rewards; a common case is borrowing more money to pay off existing debt. Mortgages are generally considered good debt in the sense that they give the borrower access to a tangible asset. However, if the borrower will struggle in the long-term repayments, mortgages can quickly become a bad debt.
All things considered, if handled with care and sufficient planning, mortgage debt can be extremely valuable. Once the debt is repaid, the reward is a tangible asset that can deliver long-term returns in the form of capital growth. However, it is vital that individuals first have a good understanding of their financial situation and engage in careful planning to stay on top of their mortgage debt.
John Ellmore is the director of KnowYourMoney.co.uk, an independent financial comparison website that was launched in 2004. Run by a dedicated team, Know Your Money’s goal is to provide clear, accurate and transparent comparisons for a wide range of financial products.