Wealth Check: How to pay off debts while growing a new business

The Patient

After starting his own business, Mark Nicholls is keen to build a cash buffer as well as wipe out debt. The entrepreneurial 27-year-old from Worcester founded The Little Green Sheep, an organic company producing chemical-free cot bedding, four years ago with a friend.

Mark used savings and took part-time jobs to supplement income during the first year. Any spare cash since then has been put back into the business to help it grow, and he now draws a salary of about £26,000 a year including dividends.

However, he has some debt to contend with. He has £9,000 in student loans and pays about £70 a month for a £3,000, four-year graduate loan with NatWest at 7 per cent that was put in place to pay off overdrafts.

"But the business is now flourishing with a wide range of exciting new products and plans to launch on to the high street," he says. "And my personal finances have also taken a turn for the better, as I have just purchased a property with my fiancée."

Mark ploughed all his savings from a few years working in a graduate job into The Little Green Sheep at launch. However, as the business has grown he has opened a Halifax share dealing account rather than opting for a cash savings account, with a current value of about £1,000.

He used to own a three-bed house in Bromsgrove, bought shortly before starting the business. "This was bought with a special starter interest-only mortgage with Cheltenham & Gloucester which was 1.99 per cent for the first year and then on a 5.88 per cent fixed-rate for the following 10 years," he says.

Since then he has purchased a two-bed house with fiancée Felicity for £153,000 in Rushwick, Worcestershire. To avoid early repayment penalties, the existing mortgage was transferred over. Also, there is an additional small top-up amount on a variable rate of 5.29 per cent with C&G for two years. "This is a short-term deal and we hope to remortgage in about a year's time. At present our loan-to-value is at 85 per cent," he says.

The couple pay about £700 a month on repayments, and they hope the property is a good buy. "It was sold to the previous owners during the housing peak for £170,000 so I hope that it will eventually be a good investment over the long term," he says.

Turning to retirement planning, he says: "I see the business as a kind of long-term pension plan." He has chosen not to invest in a private pension in the hope that the business will grow sufficiently to provide an income later in life. He has no protection policies.

The Cure

It is common for entrepreneurs to focus solely on their business and not pay enough attention to their personal finances, says Patrick Connolly from independent financial adviser (IFA) AWD Chase de Vere. "This means that Mark could effectively end up with all of his financial eggs in one basket, and if his business doesn't perform this could impact severely on his lifestyle in the future." He is wise to seek advice now that the business is proving a success, agree the advisers.

Debt

As a priority, he should pay off the graduate loan as soon as possible assuming there are no penalties involved. "This is far more important than putting money into a share dealing account, and at a far higher rate than any he could earn in a savings account – particularly in the current environment," stresses Mr Connolly.

Turning to the student loan, where the current interest rate is only 1.5 per cent, this isn't as important. "This is less than the interest he is paying on his mortgage, and so while this remains the case he should focus on repaying his mortgage in preference to his student loan," says Mr Connolly.

Salary

As the business grows, Mark can increase the salary he takes from this. A combination of salary plus dividends is the most tax-efficient way of extracting money from the company, particularly if the total gross income is kept below the higher-rate tax threshold, currently at £42,475, says John Lang from IFA Tower Hill Associates.

The extra income can then be used to pay off Mark's debt and mortgage, he adds.

Savings

Everybody should have some cash savings as an emergency fund, stress the advisers. Having this buffer can avoid the need to go overdrawn or into further debt if there are any unexpected costs, and this is particularly important in Mark's position with his business to consider.

The advisers recommend that before Mark builds up longer-term savings he puts in place an emergency cash fund of at least three months' outgoings. However, Alistair Cunningham, from IFA Wingate Financial Planning, says that while this is good advice for anyone, with a high-risk venture such as starting your own business you should aim to hold two years' of expenditure in cash.

As a start, he should save into a cash individual savings account (ISA) to benefit from cash-free interest. He is able to save up to £5,340, the annual cash ISA allowance, in this tax year.

Property

The interest rate that Mark is paying on his mortgage looks high, as those on tracker mortgages are currently paying a far lower rate than he is.

While he could achieve a lower interest rate in the short term if he switched his mortgage, if rates rise quickly he may end up paying more over the longer term if he moves elsewhere. "Many supposed experts consistently get forecasts wrong on how quickly interest rates will rise. Nobody is sure," warns Mr Connolly.

If he can reduce the loan-to-value (LTV) to 75 per cent or less he could probably secure a much lower mortgage rate than at present, says Mr Lang.

If possible, and when this is affordable, they should convert to a repayment mortgage to reduce the capital sum rather than just paying the interest on the loan.

Retirement

Mark is sensible to identify his short-term financial priorities as his debts and building up savings. However, he should also make provision for longer-term objectives as well such as saving for retirement, says Mr Cunningham.

It is "dangerous" to think of the business as a long-term pension plan as no one knows what the future holds, adds Mr Lang. However, while the business is new and expanding, it is probably not the time to be locking money up into pensions unless it could directly benefit the business.

After paying off all debt other than the mortgage, creating an emergency cash float and converting the mortgage to repayment, Mark can consider saving for the longer term with any surplus funds. The best vehicle for this is a stocks and shares ISA, agree the advisers.

Protection

Mark may think that he has limited need for any form of insurance, but an income protection policy to pay him an ongoing income if he is unable to work due to long-term illness or injury is a worthwhile consideration.

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Write to Julian Knight at The Independent on Sunday, 2 Derry Street, London W8 5HF

j.knight@independent.co.uk