Here we are at session number 27 , and I’m going to be answering the ten personal finance FAQs. I’ve been an adviser now for 15 years, and, as in every occupation I’m sure, the same questions come up time and time again. To compile this list I’ve asked many of my adviser buddies via Twitter and Facebook, plus some non-advisers too, what questions they most often face.
These are the ‘If I had a quid for every time I’ve been asked that’ questions, so I hope they’re helpful. We’re breaking from the normal format again, like we did for the ten golden rules back in session 23 – hope you don’t mind!
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OK, let’s dive into the questions:
1. Should I invest in a pension or in property?
I’ve reworded this one as a question, but more usually it’s put like this: “I don’t need a pension, because I’ve got my property”. Of course this is a stupid statement. One day, I’ll snap and when someone says that their property is their pension, I’ll take out a knife and fork and ask them to eat their house. Or I’ll ask them to go buy me something from a shop and see if the shopkeeper will accept payment in bricks!
The problem is, you can’t eat your house. To release any money to live on, you will have to sell your house, but then you’ll have to buy another house to live in, unless life in a cardboard box under the overpass sounds attractive. So I won’t give this moronic idea any more air-time – can you tell I feel strongly about this one?!
Of course, many people asking this question are genuinely asking about the merits of property investment against putting money in a pension. It isn’t a straightforward thing: pensions are not better than property, and property isn’t better than a pension. They’re very different things.
Property is an asset class, it’s a thing you can invest in which will either make you money or lose it. Over the long term, the chances are very good that you will make money in property. By the way, listen to session 10 for more on the different asset classes.
A pension on the other hand is a wrapper; a kind of box that you hold other kinds of investments in. At the risk of blowing your mind here, it’s possible to hold property in a pension! A pension is only as good as the underlying investment. There’s more on wrappers in session 11.
Investing into a pension you get tax relief, or free money from the government, and the money grows largely free of tax over the years. But the downside is that you can’t get at your money until (currently) age 55, and then you can only take one quarter of it out, the rest has to buy you an income.
Property, in turn, is illiquid, it can be difficult to sell and that can be a problem if you need to. On the bright side, there are many different ways you can invest in property, from buying and renting out property, buying, doing-up and then selling, or buying a property fund from an investment company.
So they’re different – one is not better than the other. For the best info on pensions, listen first to my interview with Rob Bence and Rob Dix in session 12, and then subscribe to their excellent Property Podcast, which is one of the most popular business and investing podcasts on iTunes, and deservedly so.
2. Should I pay into a pension or an ISA?
This is similar in a way to the last one, but a bit less clear cut. There’s no soapbox for me to climb onto here! I was asked this one only this week (again) and I’m afraid to say that once again, there’s no clear right and wrong.
Other than the tax relief on pensions, that free money from the government, pensions and ISAs are almost exactly the same in their tax treatment. The key difference is that ISAs are generally accessible, whereas pensions are not, as I mentioned just now.
The strict answer to the question of course, is both! If you can have both strings to your bow then so much the better. If you must choose one or the other, and you have neither at the moment, then I would begin with a pension. You should definitely have your emergency fund in place first. Once the pension is ticking over nicely, perhaps when you have a bit more disposable income to put away, then you can start paying regularly into an ISA too, building that up alongside while you keep paying into the pension.
This makes perfect sense if you have a pension available at work. Pay into that and your employer may match your payments – more free money. Then begin paying into an ISA when you can out of your take-home pay.
My clients who have made it to financial freedom have all saved into ISAs. Many of them have hundreds of thousands built up in these and now enjoy a tax-free income from them. This is a key advantage of ISAs over pensions: any money taken out of an ISA is tax free, whereas an income taken from a pension is taxed like salary. But with pensions you get the tax relief, so it’s six of one and half a dozen of the other.
3. The interest rates on my money saved at the bank are so poor, what are the alternatives?
This is definitely the hottest topic of the moment. Interest rates on savings accounts have dropped by a third or more over the last year. (I’m recording this in September 2013) The UK Government’s strategies for kick-starting the economy such as Quantitative Easing and it’s little brother the Funding for Lending Scheme, have flooded the financial system with cheap money and this means that the banks don’t have to offer decent interest rates to attract savers. See video episode 272 [LINK] for more details on this.
The problem is that there are very few alternatives. Now you know me well enough by now to know that this is one of my golden rules from session 23 – Cash is not an investment. I am genuinely of the opinion that bank or building society savings accounts are not a great place to hold money for the long term. They are for money you might need in the next few years, no longer. For many people of course, they may need all the money they have in that timescale, because they simply don’t have that much, and for these people this reduction in interest rates is a big problem.
The first thing you should look at is a Cash ISA, which is simply a tax free bank account. The rates are still poor, but at least you don’t have to pay tax on the interest. After that you could look to lock up some of your money for say a year, or two years. Often the banks will give you slightly better rates if you lock the money away for a time. We call these fixed term deposits.
After that though, the only way to get a better return on your money is to accept a greater or lesser degree of risk.
For people who have only ever invested with banks or building societies, risk is a four-letter word that they don’t want anything to do with, and so you end up at an impasse. Risk can be managed, though and it might just be worth a serious conversation with a competent adviser to see what could be done. There are also some investment products with guarantees, but these almost always come at the price of locking your money up for several years.
Sorry there’s no magic bullet here, but as I record this, there’s no easy answer except for careful planning, a serious and frank discussion about your tolerance for risk and capacity for loss. Good luck.
4. What order should I pay off my debts?
This is a little easier to answer definitively! I answer this one in more detail in session 4. But in summary, here are the steps you need to take.
Before you start seriously paying off debt, make sure you have a starter emergency fund in place. This is usually £1,000 and should be enough to cope with the minor emergencies life throws at us. The thinking here is that you don’t want to be paying off debt, only to have to get back into debt when something unexpected turns up.
Once you have £1,000 in the bank list all your debts in order, from the smallest, to the largest. Then, make the minimum payments on all the largest ones while paying as much as you can off the smallest debt. So the answer to the question, in my view, is you should pay off the smallest debt first.
Many will argue with this. Surely it makes sense to pay off the debt with the highest interest rate first. It absolutely does make mathematical sense, no question. And if you have a debt, god forbid, with a payday lender or pawnbroker, then yes, you should pay this off now – they are legalised loan sharks, that’s all, and you want them out of your life sharpish.
But while maths is compelling in making us want to pay off the most expensive debt first, I think that the psychological benefit of paying one debt off completely as quickly as possible. Getting an envelope in the post with a big fat zero balance from a store card company or personal loan company is a great feeling and will spur you on to tackle the next one. It might cost you slightly more in the long run, but they quick wins make it totally worth it.
Like I say, there’s much more in session 4, or in Dave Ramsay’s excellent book, the Total Money Makeover [Amazon affiliate link]. He calls this method the Debt Snowball, and I do recommend it
5. Is it better to buy a car on finance or lease it?
Ask Dave Ramsay this question and he’ll be crystal clear. He calls car leases ‘fleeces’ because he thinks borrowers are fleeced into taking them out! He has a point. With a lease, you never own a car, you just rent the use of it for so many miles over so many years. The interest rate you pay on the leases can be quite low, and it is possible to rent one or two year old cars, which always makes better sense than leasing a new car.
The logic behind leasing is that if something is going to go down in value, you don’t want to own it. Instead you want to have the use of it for a set period of time and then upgrade to a newer model. I think it was Dale Carnegie who said: “If it appreciates, buy it. If it depreciates, lease it.” This makes sense to me, as long as the maths stacks up.
Cars always go down in value, unless you happen to own a classic Ferrari 250GT. So buying them on any kind of finance doesn’t make financial sense. It is far, far better to buy for cash if possible. You’ll likely get a discount for paying cash, and you won’t be paying interest on something which is reducing in value.
Do the maths on a piece of paper: If a car costs £10,000 now and in four years, it’ll be worth £2,500, then you’re losing £7,500 over the four years. On a lease agreement, they’ll give you a guaranteed future value at the end of the term. Make sure this is in line with what the car will be worth. Add up all the payments you will make over the four years and see if it stacks up against paying cash.
There is a way you can buy a car for cash if you’re prepared to think a little differently. I explain it in one of my favourite videos, episode 245. If you can follow the instructions in this video, you need never pay any interest on a car ever again. I’m doing my best to do this.
6. How big should my mortgage be as a percentage of my monthly income?
Banks and building society are much hotter now than they ever used to be about making sure they are lending responsibly. The days of being able to borrow 125% of the value of your are, thankfully, long gone. Many lenders now employ an affordability test where they measure what percentage of your net monthly income the mortgage payment will be. So it’s not just about how much you can borrow, it’s about how much you can afford to pay back.
If you want a rule of thumb though, I would say to try not to have a mortgage payment any larger than one quarter of your net monthly income. There are so many other bills associated with home ownership: utilities, council tax, insurance, phone and broadband. Ideally all of these added together wouldn’t take any more than half your monthly income.
One important point is that right now, interest rates are at record lows. They will go up eventually, though I don’t think it’ll be for a while yet. You need to be happy that you can still afford your mortgage payment when the interest rate rises. The illustration that you mortgage lender provides when you take out the loan will usually include a suggestion of how much your mortgage might go up for every 1% rise in rates.
If you’re highly mortgaged, you could consider fixing the rate of your mortgage for a time to get used to the level of payment and protect against any rises in the rate. I talked a lot more about mortgages in session 18.
7. How much life insurance do I need?
No sense in having more life cover than is necessary ,but it’s better to have too much than too little. As a starting point I use a debt plus X rule:
- If you’re single with no dependents, just cover your debt
- If you’re in a relationship where there would be financial hardship if one partner died, cover your debt plus £250,000
- If you have children, you should cover your debt, plus £500,000
Remember this is just a rule of thumb, not a definite formula. The important thing is to work out the financial impact of your death on anyone left behind. So if you’re earning a large salary, you have kids and your partner doesn’t work, you may well need significantly more than £500,000 of life cover.
One quick point: don’t use whole of life insurance, instead stick with term life insurance – it’s much better value. Listen to session 7 for more detail and definitely seek advice on getting the level of your life cover right – it’s so important
8. How safe is my money with ‘X’?
This one never came up until the financial crisis of 2007-2009. When people saw queues outside branches of Northern Rock on the TV in late 2007, this was the first major run on a bank in 100 years. Since then, people have understandably been far more concerned than they ever used to be about the safety and security of their money.
The dark days of the credit crunch are, mercifully, behind us now. But still this question comes up often.
I believe that most of the financial institutions still standing after the credit crisis are strong enough not to worry about. The government has set a bit of a precedent that it will step in if it thinks any major financial institution might fail. That really means banks, building societies and maybe insurance companies, as opposed to investment managers. The bigger the company is, the less likely the government will allow it to fail.
That said, you must not rely on this. The ONLY way to be absolutely sure that you will get your money back if things go very badly pear-shaped is to stay below the maximum compensation limits under something called the Financial Services Compensation Scheme.
The FSCS will pay compensation if the company with whom you have invested cannot honour its commitment to you. The maximums are:
For investments: £50,000 per person per institution
For bank accounts: £85,000 per person per institution
For insurance products: 90% of the insured amount with no upper limit
So practically speaking: Don’t invest in a company you’ve never heard of without doing some research and stay within the FSCS limits where possible. For very wealthy people, keeping less than £85,000 in each bank simply sin’t practical – they would have 50 different bank accounts. Use your common sense and don’t be completely paranoid.
9. How much money can I give to my children?
I love this question. When I get asked this, I always answer with: “as much as you want, it’s your money!” People look confused and then I clarify.
This is basically true though. You can give as much of your money to your kids as you want because it is your money. But people asking this questions are more concerned about the inheritance tax or long term care implications of giving money away.
I talked a lot about Inheritance Tax in session 9, so listen to that for more detail, but essentially if you give money away, it is added back into your estate if you die within seven years, when the inheritance tax due is calculated. To put it another way, if you die within seven years of making a gift to someone, the revenue may add some or all that gift back into your estate when they work how much tax your estate has to pay.
There are all kinds of allowances and reliefs available which are covered in session 9, but here’s a great rule to follow. Don’t do (or not do) something for tax reasons, that you wouldn’t otherwise do. In other words don’t let tax implications stress you out too much. Consider them, sure, but do what you want to do at the end of the day.
If you give some money away, and then later you need long term care paid for by the local authority, you may run into problems. I’m going to be covering long term care planning next time so stay tuned. For now, just be careful. If there is any suggestion that you have given money away to avoid paying for care fees, you’re in trouble.
10. How much do I need to retire?
How long exactly is a piece of string?! This answer to this question is obviously different for everyone, and the job of a decent financial planner is to try to find this number for you.
Realistically, if you are more than ten years from the date of your intended retirement, you’re going to find it quite difficult to be too precise, but a good planner will get close.
You need to add up all the likely sources of income in your old age, expressed in today’s money. There is no other kind of money that is worth bothering with. Today’s money is the only kind we can understand. We know what our income is now, and we know how much things cost today.
Add up all those sources of income and then work out what your outgoings will be, assuming you’ve paid off your mortgage (hopefully). You’ll still have to pay council tax, electricity and all that. You will want holidays presumably. Maybe you want to change your car every three years. Try to get a handle on what the ideal retired lifestyle will cost. Then add 20% for underestimation.
Take off this the income sources you know about, like your state pension (work on £140 per week) and any company pensions you know about. So you have a desired income, less the income from these sources, which leaves the income you need to find. Multiply this figure by 25 and you’re probably somewhere near.
Here’s an example: Say you think you can have a nice life on £30,000 per year, and you know you will have pensions of £12,000. This leaves £18,000 difference you’re going to have to find.
Multiply £18,000 by 25 and you get £450,000. A fund of this size should mean you can get the income you want, after tax, plus covering inflation.
But, as ever, get advice on this one. If you’re more than ten years from retirement, just put as much as you can into pensions and ISAs and you’ll probably be OK.
Ok, that’s your ten questions answered. I can see me doing this a couple times a year. As more questions get asked, I’ll make a note and cover them in due course.
If you have a specific question you want answered quickly, the best way is to leave me a voicemail at meaningfulmoney.tv/feedback. I’ll play it into the next available show.
That's it for this session of the MM podcast, I hope it was helpful. Did I miss anything? Do you have any questions? If so, please leave them in the comments below.
If you like what you hear on this podcast, please leave a rating or review on iTunes by going to meaningfulmoney.tv/iTunes. This helps others to hear about the show and to subscribe, because it keeps me near the top of the rankings.
I hope you enjoyed this session. Next time we'll be talking about long term care planning. Maybe you’re worried about this yourself, or have a parent whom you are worried about needing care.
If you have any questions about this, go to meaningfulmoney.tv/feedback and leave a voicemail soon.
Thanks for listening – I'll talk to you next time