Save or overpay your mortgage
Deciding whether to save extra money or use it to pay down your mortgage faster is a crucial financial decision that can impact your long-term wealth and security.
This choice is more than just a numbers game; it's about understanding your priorities, future plans, and how your financial decisions today can shape your tomorrow.
The right approach depends on multiple factors, including your financial goals, risk tolerance, and mortgage conditions. While both saving and overpaying have distinct benefits, choosing the optimal strategy is about balancing security, growth, and long-term savings. In this guide, we'll walk you through the key considerations to help you make a decision that best fits your circumstances.
By the end of this guide, you'll have a clearer understanding of how to assess your options and align them with your broader financial objectives. Whether you're looking to eliminate debt faster, build emergency savings, or invest for the future, we've got you covered.
SAVE
Liquidity:
Savings are generally easy to access in emergencies, providing financial flexibility.
Flexibility:
You can change your mind later and access your savings if needed, offering flexibility.
Low Returns:
Savings accounts may not keep pace with inflation.
OVERPAY MORTGAGE
Reduced Liquidity:
Once you overpay your mortgage, typically those funds are tied up in your home.
Reduces Debt Faster:
Overpaying could potentially save you thousands in interest.
Better Alternatives May Exist:
Repaying higher-interest debts or investing your money may offer better returns.
1. Saving overview
Deciding whether to save or repay your mortgage is a crucial part of financial planning. While saving offers flexibility and security, especially for emergencies, repaying your mortgage faster can help reduce your long-term debt and interest costs. Let's explore the key factors to consider with each option.
Saving generally involves putting money in low-risk, liquidLiquidity refers to how quickly and easily you can access your money without losing value. accounts that are accessible if needed. The primary goal is to keep funds secure and available while earning some interest, though savings rates are often lower than mortgage rates.
- Purpose: - Saving is typically for short-term needs or unexpected expenses, such as an emergency fund, or near-term goals like a holiday or home improvements.
- Low risk to capital: - Savings accounts, cash ISAs, and premium bonds offer security and protection against loss of capital, making them a low-risk option.
- Liquidity: - Savings accounts provide easy access to funds, making them ideal for emergencies or immediate financial needs.
- Growth: - While savings accounts provide safety, they usually offer modest returns that may not outpace inflation or the interest rate on your mortgage.
2. Reasons to prioritise saving
Building savings is a crucial foundation for financial security. Prioritising savings can provide peace of mind by ensuring that funds are available for unexpected expenses or planned purchases. It also helps avoid relying on credit and taking on additional debt. Here are key reasons why focusing on saving might make sense, especially if you're still building a financial cushion.
- Emergency fund: - Having an emergency fund is essential for financial resilience. Most experts recommend setting aside 3 to 6 month's worth of living expenses in a liquid, easily accessible account. This fund acts as a safety net for unexpected situations, like car repairs, medical expenses, or temporary job loss.
- Short-term goals: - For planned expenses in the near future (1 to 5 years), such as a vacation, home improvement project, or wedding, keeping money in savings ensures you can cover these costs without disrupting your mortgage payments or other financial goals.
- Liquidity Needs: - Savings accounts offer high liquidity, meaning you can access funds quickly when needed. This is especially useful in emergencies or to cover immediate costs without needing to take on additional debt, giving you greater flexibility and financial stability.
3. Drawbacks of saving
While saving offers many advantages, it's important to consider some of the potential downsides, particularly if you are carrying mortgage debt. Saving instead of repaying your mortgage could result in higher long-term costs. Let's explore why.
- Lower Returns: - Savings accounts usually offer modest interest rates that may not keep up with inflation or the interest on your mortgage, meaning your purchasing power could decrease over time.
- Missed Opportunity to Reduce Debt: - Making extra mortgage payments directly reduces your debt and the interest you'll pay over the loan's life, a benefit that saving alone cannot provide.
- Inflation Impact: - Inflation can erode the value of cash in savings, especially if the interest rate on your savings is lower than inflation, effectively decreasing the real value of your money.
- Potential Lost Interest Savings: - If your mortgage interest rate is higher than the return on savings, prioritizing savings over mortgage repayments may lead to higher overall costs in the long run.
4. Return on savings vs cost of debt
When deciding between saving or repaying debt, it's helpful to understand AER (Annual Equivalent Rate) and APR (Annual Percentage Rate). Both are percentages representing the cost or return on a given amount of money, but they serve different purposes.
Annual Equivalent Rate, AER
Annual Equivalent Rate, or AER is the rate of interest you earn on savings over a year, taking into account the effects of compunding. It allows you to compare different savings accounts on a like-for-like basis, highlighting which option offers the highest growth potential.
- Purpose: - AER is used to represent the effective interest rate on savings and investment accounts. It takes compounding into account, making it useful for comparing the growth potential of different savings products.
- Consideration: - AER rates are generally lower than typical mortgage interest rates, meaning that while saving can grow your funds, paying off mortgage debt might result in greater overall savings by reducing interest payments.
Annual Percentage Rate, APR
Annual Percentage Rate, or APR reflects the total cost of borrowing, including both interest and any associated fees. It provides a clear picture of how much a loan will cost you over a year, helping you compare different borrowing options effectively.
- Purpose: - APR helps borrowers understand the total cost of a loan or mortgage by including not just the interest rate but also any additional fees. This makes it easier to compare loan products.
- Consideration: - Comparing the APR on your mortgage with the AER on potential savings or investments can help you decide whether to save or repay mortgage debt, as repaying high-APR debt could lead to greater financial benefits over time.
Summary
AER is used to calculate the percentage return on savings, showing the interest you would earn annually. APR, on the other hand, represents the percentage cost of debt, reflecting what you would pay in interest each year on a loan or credit.
Essentially, both rates work similarly in that 10% of £100 is £10 — whether it's interest earned on savings or interest owed on debt. Knowing these rates helps you make informed choices about saving versus repaying debt, but there are further considerations to be aware of.
5. Tax treatment on savings income
When considering the advantages of saving versus repaying debt, it's essential to understand the tax treatment on savings interest. The government offers several tax-free allowances on savings, allowing you to earn interest without incurring tax up to specific limits.
Personal Allowance
If you haven't fully used your Personal Allowance on wages, pensions, or other income, you can apply it to interest on your savings, enabling a portion to be earned tax-free.
Starting Rate for Savings
In addition to the Personal Allowance, you may qualify for a starting rate for savings, allowing up to £5,000 of tax-free interest if your other income (such as wages or pension) is below a certain threshold:
- Income under £17,570: - You may be eligible for up to £5,000 in tax-free savings interest. For every £1 of other income above your Personal Allowance, your starting rate for savings decreases by £1.
- Income over £17,570: - You're not eligible for the starting rate for savings.
Personal Savings Allowance
Beyond the starting rate, you may also benefit from the Personal Savings Allowance, allowing up to £1,000 of tax-free interest based on your tax band.
| Income Tax Band | Personal Savings Allowance |
|---|---|
| Basic rate | £1,000 |
| Higher rate | £500 |
| Additional rate | £0 |
Individual Savings Accounts (ISAs)
For additional tax-free savings, ISAs offer a tax-efficient option. Interest and income generated within ISAs are exempt from tax, making ISAs a valuable choice if you've used up your Personal Savings Allowance and starting rate for savings.
| ISA Type | Annual Allowance |
|---|---|
| Overall ISA allowance | £20,000 |
| Lifetime ISA (LISA) | £4,000 (counts towards overall allowance) |
| Junior ISA (JISA) | £9,000 (per child) |
Note: You can split your allowance between a stocks and shares Isa, cash Isa, lifetime Isa and innovative finance Isa. For more informaiton on ISA allowances read our guide.
6. Tax treatment on debt repayments
Unlike savings interest, repaying debt is not subject to tax making the effective return on overpaying debt equal to the loan's APR (Annual Percentage Rate).
When your savings interest is taxed, repaying high-interest debt can offer a greater financial advantage. By reducing debt, you effectively gain a “return” equal to the debt's interest rate, which is tax-free. This makes debt repayment especially appealing when your savings are taxed.
7. Save vs ovepay mortgage projections
Try our simple to use calculator to calculate the growth of a savings account and project investment growth for high, medium and low risk portfolios.
For greater functionality try our stand-alone
save or repay mortgage
calculator.
Calculator
Mortgage balance:
Mortgage term remaining:
Fixed rate:
Fixed rate end-date:
SVR:
Monthly overpayment:
Savings rate:
RESULT:
BETTER-OFF BY:
Interpreting the result
8. Other factors to consider
While this model offers insights into the potential outcomes of saving versus mortgage repayment, it's important to understand its limitations. Real-world factors and individual financial situations can influence outcomes in ways the model may not fully capture. Here are some of the key limitations and other considerations to keep in mind.
Model limitations
- Savings interest rate: - The model assumes q fixed savings interest rates. However, real savings rates may vary due to economic shifts, central bank policies, or inflation, impacting actual returns on savings.
- New mortgage fixed rate: - Changes in fixed-rate mortgages at renewal points aren't always captured by the model. Economic conditions could impact the rate offered when your fixed period ends, influencing whether saving or repaying is more advantageous.
- SVR changes: - Standard Variable Rates (SVR) can change over time, often influenced by macroeconomic conditions. The model does not reflect these shifts, so any variable rate mortgage scenarios may vary from actual results.
- Tax implications: - The model estimates gross returns but does not always factor in specific tax impacts on savings, which can reduce net returns and affect the balance between saving and mortgage repayment benefits.
Wider considerations
- Economic and market variability: - Economic downturns or inflation could impact both mortgage rates and savings yields. In tougher times, access to savings may be critical, which isn't reflected in the model's assumptions.
- Behavioral factors: - The model does not account for personal financial habits or changes in spending behavior, which can influence the effectiveness of a savings or repayment plan over time.
- Unforeseen financial changes: - Life events like job loss, health issues, or major unexpected expenses are not reflected in the model but can greatly impact financial priorities and the feasibility of either saving or mortgage repayment.
9. Alternative options to consider
Beyond traditional saving or mortgage repayment, diversifying into other asset classes may provide additional growth opportunities and risk management. Here are some alternative options that may align with broader financial goals.
- Bonds: - Bonds are generally considered a lower-risk investment compared to equities and can provide a fixed income over time. They are an option for those seeking steady returns without the volatility of the stock market, though returns are often lower than stocks.
- Commodities: - Commodities like gold, silver, and oil offer a hedge against inflation and can provide a safe haven in times of economic uncertainty. While they can add diversification, commodity prices can be volatile and may not suit all risk profiles.
- Real Estate Investment Trusts (REITs): - For those interested in real estate without the commitment of physical property ownership, REITs allow investment in real estate assets and may generate income through dividends. This can provide exposure to the real estate market with more liquidity than direct property investment.
- Stocks and equities: - Investing in individual stocks or equities through an ISA or General Investment Account (GIA) allows for potentially higher returns but comes with market volatility. Equities can play a strong role in long-term wealth building for those comfortable with market risks.
- Pension contributions: - Making contributions to a pension provides tax advantages and is an effective way to build long-term financial security, especially for retirement. Pensions grow tax-free and often come with employer-matching contributions, making them a valuable asset class.
10. Checklist
Before deciding between saving and repaying debt, use this checklist to evaluate your financial priorities. Key areas like maintaining an emergency fund, managing high-interest debt, and setting clear financial goals play essential roles in determining the best approach.
- Emergency fund: - Ensure you have 3 to 6 months' worth of living expenses in an emergency fund. This fund provides stability during unforeseen events or income disruptions, acting as a financial cushion so that you don't need to rely on high-interest loans or credit cards in times of need.
- High-interest debt repayment: - High-interest debt, such as credit cards or personal loans, can significantly reduce your financial flexibility. Paying down these debts should be a priority since the interest accrued is often higher than returns from low-risk savings.
- Short-term goals (0-5 years): - Make sure you have a savings plan for upcoming short-term goals, such as vacations or home improvements. Remember, once an overpayment is made toward debt, those funds are not long accessible.
- Long-term financial goals (5+ years): - Ensure you have a clear plan to save for long-term financial objectives, such as retirement. Keep in mind that mortgage overpayments are typically irreversible, so consider whether investing might better support your overall financial flexibility.
- Interest rate comparison: - Compare your mortgage rate with potential returns from other asset classes. If your mortgage rate is relatively high, overpaying may yield better results than low-yield savings accounts, however, investments in diversified assets could potentially provide greater returns if you're comfortable with associated risks.