1. The importance of finance management

Financial security is something many people take for granted. But when you no longer have it, it quickly becomes apparent how important it is to manage your resources. We need money to live – it’s how we pay for our homes, food, leisure, transport and other daily expenses.

Not having the money available to pay for your bills can land you in a lot of trouble. People often describe debt as something that spirals out of control. For example, just paying off the minimum on a credit card means you’ll quickly rack up interest payments and fall behind, trapping you in a cycle.

And credit cards are just part of the story – payday loan debts are on the rise, and illegal loan sharks in the UK continue to target the poorest households. When financial problems arise, people often turn to these kinds of high-cost credit solutions. But an immediate fix tends to cause more issues than it solves, as people are unable to pay back the interest.

According to Totally Money, only 1% of UK adults were able to correctly answer how long it would take to pay back £2,000 on a credit card if you’re only making the minimum payment every month (APR of 18%, minimum payment is 2% of the outstanding balance or £5, whichever is the greater). Here’s a breakdown of how long it would take:

  • After five years, you’ll have paid back over £2,000 but only cleared £638.54 of your original debt – the rest has gone on interest
  • After 10 years, you’ll have paid £3,406.05 – 59% of UK adults thought they’d be debt free by now
  • It would take 34 years, 3 months

Most people vastly underestimate the length of time it takes to clear credit card debt. Mismanaging your money can have huge impacts on your life – for a long time. Getting the hang of financial management, by learning how to budget and manage key expenses, is a skill you’ll use throughout life.

a. How prevalent is debt in the UK?

More than 8m Brits are now in debt, according to the Guardian. Excessive personal debt is a problem many people will experience in their lifetime. But it’s important to remember debt can be managed and it’s not something that’ll affect you forever. However, the current state of play in the UK is as follows:

  • People in the UK owed £1.516 trillion at the end of December 2016 – this is a rise of £995.53 per adult from the previous year
  • The average total debt per household (including mortgages) was £56,153 in December 2016
  • Based on December 2016 trends, the UK’s total interest repayments on personal debt over 12 months would have been £50.395 billion – on average, that means households in the UK would have paid £1,866 in annual interest repayments
  • Household debt is predicted to reach £2.294 trillion at the start of 2022
  • Outstanding consumer credit lending was £192.95 billion in December 2016 – per household, that’s an average of £7,146
  • Total credit card debt was £67.9 billion in November 2016 – per household, that’s an average of £2,465
  • Source: The Money Charity

These statistics paint an alarming picture. But not all debt is bad. You’ll need to borrow money at some point in your life – to get a mortgage, buy a car, or finance university, for example. Few people have the money upfront to buy a house, especially as the average UK house price was £216,750 in 2016 and continues to rise. So debt is a necessity – it’s just about borrowing money and being able to manage repayments.

b. The main causes of debt

Armed with the understanding that not all debt is bad, it’s important to understand what causes debt and find out what the warning signs are for when borrowing could get out of hand. Although they won’t lead to debt in all instances, the following things are some of the main causes of debt:

  • Overspending. Spending more than you earn is known as living beyond your means. It’s not something people can keep up for long, before they start needing extra money from loans.
  • High interest charges. If you’ve borrowed money in a rush, you might not have properly understood the interest rates. They can catch people out – and cause debts to spiral quickly.
  • Expanding families. As your family grows, so too will your expenses.
  • Poor investments. Investing your money can earn you a fortune, but only if you’re experienced at making the right calls. You can easily lose just as much with a few poor choices. Leave it to the experts.
  • Emergency situations. You can’t plan for every cost in your life. Some things catch you by surprise, including medical costs, divorce, gambling habits, and unemployment.

Ultimately, debt is usually caused by a lack of solid financial knowledge. It’s not something they teach in school – you’re supposed to figure it out for yourself. But money management doesn’t come naturally to everyone. If your income suddenly reduces, but your expenses stay the same, it can be frightening. Some people bank on a windfall, while others rely heavily on credit cards. But the only way to succeed is to manage your existing finances.

How do you work out how much you should be spending, and how much you should be saving? Many people won’t realise how much the cost of living goes up each year – as inflation rises, housing, food, petrol, and other key things, are more expensive. But that doesn’t necessarily mean your salary will. So the amount you’ll be spending, as well as how much you should save, changes over time. For example, money saved 10 years ago would be less valuable now, because you’d be able to buy less due to inflation.

The rest of this guide will help you evaluate your current situation, and give you top tips for the future.

c. Credit scores explained

First up, you need to understand what your credit score is, and who uses it. Lenders can access your credit reports to decide whether you’d be able to manage repayments.

A credit score or rating expresses your ‘creditworthiness’ – in other words, if you have a good track record of making payments on time.

They use a mathematical calculation to score your credit history and work out what kind of borrower you are. It will determine whether your application for a credit card or mortgage is accepted, for example, and what interest rate you’ll have to pay.

Over time, your credit score will change as new information is generated by your spending and borrowing behaviour.

What do lenders use to work out your credit score?

A credit report will provide lenders with information such as:

  • How much of your available credit you’re using
  • Total debts
  • History of credit account payments
  • When you’ve made credit applications in the past
  • Public records

Without enough credit information, credit scoring models cannot work out a score.

Who is my credit score used by?

Any business that issues credit or loans will use your credit score to summarise your credit history quickly, including:

  • Banks
  • Credit card companies
  • Car dealers
  • Retail stores

Your credit score is used as a leading indicator of whether you’re credit-worthy. But it’s not the only factor – banks, for example, will also look at your income compared to the size of the loan.

d. The benefits of efficient budgeting

Efficient budgeting will help you use your available credit well, as well as pay off debts on time – things that count towards your credit score and give you access to more money in the future. But there are more benefits of budgeting, including:

  • Reduced stress. Money problems inevitably cause stress. Knowing what your financial situation is, and what you should be spending, helps take some of those worries away.
  • Future planning. By budgeting well, you’ll be in a better position to save up for treats – a holiday, a new car, or the latest gadgets, for example.
  • Greater flexibility. Budgeting means you’re more likely to spot areas where you can make savings, as well as to have a good credit rating – opening up opportunities for you, such as getting a mortgage.
  • Better prepared for emergencies. Of course, you can’t plan for all kinds of financial emergencies in your budget. But should your car breakdown or a pipe burst, knowing what money you have available ensures you’ll be able to respond quickly and fix the problem without getting caught out by unexpected costs.

According to The Money Advice Service, over half of UK households keep a regular budget.

Most say it gives them peace of mind about how much they’re spending, and makes them feel better about life in general.