Pay off your credit card before your mortgage deal!

Rachel Robson investigates whether you're better off putting your spare cash towards your mortgage deal or credit card debt...

Here at lovemoney.com, we believe there are five key steps you can take for a richer future.

One step is to overpay on your mortgage. After all, if you're lucky enough to be on a tracker mortgage right now, you'll no doubt be benefiting from a very low rate of interest. So it makes perfect sense to pump more money into your mortgage, pay it off early, and save yourself some money (providing your lender lets you of course).

But what if you have some credit card debt as well as your mortgage? Should you still make paying off your mortgage your priority, or should you put that extra cash towards clearing your credit card debt instead?

The snowball effect

At lovemoney.com, we've always said that, as a general rule of thumb, you should pay off your most expensive debts first, and leave the cheapest debts until last. This is purely because your most expensive debts will be growing at the fastest rate - so by paying these off first, you'll clear your debt more quickly.

This method is known as snowballing.

Let's say you have two credit cards, all of which have around £500 of debt on them. One is a store card you got from high-street chain Argos, which has a typical interest rate of 27.9% APR, while another - the Barclaycard Goldfish Credit Card - typcially charges 9.9% APR. 

If you can, you should try to transfer your debts on both the Argos store card and the Barclaycard Goldfish Credit Card onto a 0% balance transfer card. So you'd clear your balances entirely on the other cards, leaving you with £1,000 to pay off on your new, interest-free credit card. You should try to pay off before the 0% interest promotional period expires.  

But what if you can't get a 0% card or don't want the hassle of transferring all those balances? Then, the best way to tackle these debts is to focus on the most expensive debt first. In this case, it's the £500 debt on the Argos store card with an interest rate of 27.9%. Set up a standing order for the minimum monthly repayment on all your other cards and then throw as much money as you can at this card.

Once you've cleared the £500 debt on the expensive Argos store card, move on to the next most expensive debt - the Barclaycard Goldfish Credit Card charging 9.9% in this example. 

By following this method, you'll clear your debt far more quickly and save yourself interest.

To overpay or not to overpay

Ok, so we've got to grips with the method of snowballing credit cards. But what happens when it comes to choosing between paying off your credit card debts first, or overpaying on your mortgage?

Let's say you have £3,150 on your credit card which is charging a typical interest rate of 16% APR. As well as this, you have a £150,000 tracker mortgage, which, thanks to the base rate cuts, is now sitting at a measly 1% - meaning your monthly mortgage payments are now far lower than they were a few months ago.

Because you're now paying less each month towards your mortgage, you've got a fair bit of extra cash knocking around. So what do you do with it? Is it better to throw it at your credit card debt or overpay on your mortgage?

Using the above advice about snowballing, it would seem logical to use that extra cash to pay off your most expensive debt - your credit card.

But is this really the best solution?

Let's do some investigating.

Your mortgage debt

If you have a 25-year mortgage for £150,000 at 1%, you'll pay £19,582 in interest over the course of the mortgage term.

This is assuming the mortgage rate remains at 1% for 25 years.

And unfortunately, this is pretty unrealistic.While rates are low at the moment, they are very likely to go up in the near future, never mind over the next 25 years.

Of course, no one knows how mortgage rates will fluctuate over such a long period - but we can try to predict the next few years at least. So, let's assume that your mortgage rate rises gradually over the next three years - say, by one percentage point in a year's time (to 2%), and then another one percentage point in two years' time (to 3%), and then two percentage points in 2012 (to 5%). Let's assume - albeit optimistically - that it then remains at 5% for the rest of the mortgage term (22 years at this point).

If this happened, your monthly payments would rise dramatically, to £828 a month, and you'd end up paying £96,649 in interest on your mortgage over the full term.

Option 1 - overpaying your mortgage 

So how does this compare to if you decide to overpay on your mortgage, £500 every month for six months?

Well, again assuming your mortgage remained at 1% throughout the mortgage term, it would take you 24 and a half years to pay off your mortgage in full, during which time you'd pay just £18,761 in interest.

So, by overpaying on your mortgage you'd pay it off six months earlier and save yourself £821 in interest. Nice one!

But what about the more realistic scenario, where the rates gradually rise over the next three years? In this case, you'd save even more by overpaying. In total, you would only pay £95,378 in interest, instead of £96,649. So you'll save yourself £1,271 in interest by overpaying for six months now. 

As you can see, overpaying on your mortgage is a very good long-term strategy - especially if you agree that rates are going to rise at some point over the next 25 years.

But is it the best strategy if you've got credit card debt?

Your credit card debt

If you'd chosen to put that extra £500 a month towards your mortgage and simply paid the minimum monthly repayment of 3% on your credit card, it would take you an eye-popping 17 years and 6 months to clear the £3,150 of debt on your card. And you'd end up paying £2,213 in interest over those years.

Option 2 - overpaying your credit card

If, on the other hand, you'd overpaid by £500 a month on your credit card instead of your mortgage, you'd have paid it off entirely in six months.

So by putting the spare cash towards your credit card, not your mortgage, you'll save yourself a £2,213 in interest over the long-term and you'll pay off the debt 17 years earlier!

That's almost £1,000 more than you'd have saved if you'd overpaid on your mortgage by the same amount. And psychologically, you may find that getting rid of your credit card debt almost two decades years earlier makes you feel more confident and in control of your finances.

The verdict

I think it's pretty clear that in the long run, you're much better off putting any spare cash towards your credit card debt rather than choosing to overpay on your mortgage.

Why is this? Although your mortgage is a much larger debt and therefore it might seem logical to throw more money at it, because your credit card debt has a much higher rate of interest, it actually makes more sense to focus on clearing that debt first. So the idea of snowballing triumphs once more!

Having said that, the closer your mortgage interest rate gets to your credit card interest rate, the smaller the difference is between paying off your mortgage and paying off your credit card debt. So watch out for rising mortgage rates, and try to fix in at a low rate before rates rise significantly.

Similarly, if you can overpay for a longer period now, the amount of interest you save on your mortgage will be more significant over the long term.

The best way forward

If you truly want to get rid of your debts as quickly as possible, overpaying should not be your only strategy. You should also try to transfer your credit card debts to a 0% balance transfer card (as I mentioned earlier). That way, 100% of your monthly payments will go towards destroying your debts, and you won't pay any interest. The market-leading 0% card at the moment is the Virgin Money balance transfer card, which offers 0% on balance transfers for 16 months (with a 2.98% fee).

Alternatively, you may prefer a lifetime balance transfer card that allows you to pay off your debts at a low rate over a longer period. The Barclaycard Simplicity card charges just 6.8% APR (variable) and, unlike the Virgin card, there's no balance transfer fee.

Since these cards charge far less interest than the typical 16% APR used in the examples above, you'll be able to pay off your debts much more quickly when you make your overpayments. And the sooner you destroy your credit card debt, the sooner you'll have extra money in your monthly budget to put towards overpaying on your mortgage - so you'll get the best of both worlds.

Of course, if you never had any credit card debts to pay off in the first place, then it is definitely a good idea to overpay on your mortgage. Just don't forget that if you are planning to do this, you need to check exactly how much you're allowed to pay off before you start incurring penalty charges (known as Early Repayment Charges). In some cases, you'll only be allowed to overpay by a maximum of £500 a month, or 10% a year. So make sure you ask your lender first.

But if you have got credit card debts to pay, seriously consider putting any spare cash towards them today! The savings really are vast!

Many thanks to the This Much I Know blogger Dave, for providing this great mortgage overpayment calculator. You can also use our interest calculator and our  overpayment calculator to look at the impact if rates change.

You can work out a credit card calculator yourself in a spreadsheet. Put the amount you want to pay off in A1. In A2, put your monthly interest rate, multiplied by A1. To find out the monthly interest rate, divide your APR by 12, then add 100. Don't forget to put a percentage sign. So A2 should be: A1 multiplied by 101.333333% for a credit card charging 16% APR. In A3, put your monthly payment. The minimum is usually 3% of your outstanding balance. In A4, take your payment away from your debt. So A2-A3. This gives you your balance after month 1. Repeat this sequence until you get to the end of the period you want to overpay for. This fantastic minimum monthly repayment credit card calculator from lovemoney.com reader dd may also be useful.

Thanks also to lovemoney.com reader Ewen Ferguson for his help.