If you’ve got some spare cash, is it better putting it in a savings account, or should you use it to overpay your mortgage?
With both mortgage rates and interest rates on the up, following a series of increases by the Bank of England, it’s a good time to reassess the best place for your extra cash.
Though it’s also worth thinking about your pension and investments, this article is focussing on whether you should keep the cash in savings or use it to overpay your mortgage.
To help you work out which one is best for you, I’ve got a series of questions to ask yourself.
Do you have any debts?
Before we even talk about savings and mortgages, we need to tackle your debts. With the exeption of any 0% credit you have and possibly your student loans, it makes sense to clear those expensive credit cards, overdrafts and loans as a priority.
So whether you’ve got a lump sum already or have spare cash left each month, transfer it to wipe out those debts.
Winner: Non-mortgage debts
Do you have an emergency fund?
Once those debts are clear, it’s time to build up an emergency fund. This is vital in the event you can’t work or lose your job, but it’ll also be there to cover things like broken boilers or a failed MOT.
Ideally aim for enough to pay for three to six months of essential expenses like your mortgage and bills. You might want to have a larger pot, especially if you have an irregular income.
Though you can get cash out of a property if you need to, this isn’t easy and it won’t necessarily be without additional costs. So save, save, save.
Do you have any big expenses in the near future?
And saving doesn’t stop if you know there’s something on the horizon, from a holiday or new kitchen through to Christmas costs or a new phone, which you’ll need cash for.
It does depend on how far away these expenses are likely to be and how fast you think you’ll be able to save up for them, but broadly these should be your next priority over putting more into your mortgage.
So unless you have nothing big coming up and you’re confident you won’t need access to the money, it makes sense to keep adding to your savings until you have built up enough that you won’t need to borrow later.
What are the interest rates?
So, let’s assume you’ve cleared your debts and now have some healthy savings for both emergencies and upcoming expenses. Then what?
Well, when it comes to further spare cash you need to compare the interest rate on your mortgage and what you can get on your savings.
At the most simple level you want to put your money into the highest paying option. Say there’s £500 spare each month. If your mortgage is 3%, overpaying will save you £97 in a year. But putting that in the best easy-accss savings account (currently at 1.56%), will earn you £51. So you’ll save almost double the amount in interest by adding it to your mortgage.
It could be that this is a mixed approach. Right now the best regular saver account is 3.5% with First Direct (check the latest top paying accounts here). The most you can pay here each month is £300, so the remaining £200 (from the example £500 extra cash) might then go on the mortgage.
Winner: Whichever has the highest interest rate
Do you pay tax on interest earned?
You’ll also need to factor in whether you pay tax on your interest. Most of us can earn either £1,000 or £500 tax-free thanks to the Personal Savings Allowance (PSA), so it’s a simple comparison.
But if you are paying tax, say 20%, an interest rate of 3.5% suddenly becomes 2.8%. At 40% it drops to 2.1%. Here’s more on tax on your savings and the PSA.
Winner: Whichever rate is higher if tax is deducted from savings interest
What’s your LTV and when are you remortgaging?
Overpaying your mortgage doesn’t just reduce the length of the loan and cut how much total interest you’ll pay, it also builds up equity in your property at a faster rate. And this can be vital when it comes to remortgaging.
When you first got your mortgage, it was probably with something like a 10% deposit, meaning you had a Loan-to-value (or LTV) of 90%. You tend to get access to lower interest rates with lower LTVs, which go down as far as 60%.
As you make the regular repayments that number starts to decrease, and if you overpay that happens faster. The problem is these LTVs drop in tiers, usually 95%, 90%, 80%, 75%, 60%.
So it could be that you want to prioritise overpayments rather than savings so you can get to (or just below) the next tier when you come to remortgage.
WINNER: Overpayments if it helps you drop an LTV tier
Are there limits on how much you can overpay?
Sadly you might hit a stumbling block when you come to overpaying your mortgage – there could be a limit. In fact, you might not be able to overpay at all.
If you can’t find details yourself, just contact your mortgage lender to find out their rules on overpayment. Most common is 10% of the outstanding loan every 12 months, though there could be no limit at all.
With either, you need to be careful of early repayment charges on top. These could come about when you go over the 10% or when you clear the whole debt before the mortgage deal expires.
You can avoid the latter by asking your lender to reduce the size of the monthly repayment so it finishes on time.
Winner: Savings if you’d go over any limit
Is mortgage interest calculated daily?
Most mortgage deals will now charge interest on a daily basis. But if you have an older one where it’s added to your loan monthly or even annually, then you might want to delay when you make your repayment.
An overpayment only reduced interest payments if it’s taken into account before the next calculation.
So if you add money the day after it’s been sorted for a year, you’ll pay the full interest for that year regardless of extra money added (until the next calculation is made).
In this instance, it might be better to put it in savings at the best rate possible, then use it for the overpayment a few days before the interest is added to your mortgage.
WINNER: Savings until just before interest is calculated
Listen to Cash Chats, Andy’s twice-weekly podcast. Episodes every Tuesday and Friday.