Save More Or Pay Off Your Mortgage?

With the base rate at a 314-year low, many mortgages are ultra-cheap. Thus, it can make sense to save instead of overpaying your home loan.

Last month, my Foolish friend Rachel Robson wrote about how to Make The Most Of The Base Rate Cut. Rachel's idea was simple: when mortgage interest rates fall, you benefit from lower monthly repayments. So, why not put this extra cash to work by overpaying your mortgage and accelerating its demise? By shortening the life of your loan, you could save yourself a small fortune in interest.

While overpaying your mortgage is a great idea, you may be able to make your money work even harder. Rather than lowering your mortgage and the amount of interest charged, it may be possible to earn better returns by sticking your spare cash in a savings account.

Savings versus mortgages

Recently, I tried to convince a relative to go down the savings route, rather than overpaying his mortgage. My relative has a tracker mortgage, as do around two in five (40% of) mortgage borrowers. His mortgage tracks the base rate, plus 0.8% on top. In other words, with the Bank of England base rate cut to an all-time low of 2%, he is paying an ultra-low mortgage rate of 2.8% a year.

My relative is a basic-rate taxpayer, so he loses a fifth (20%) of his savings interest to HM Revenue & Customs. Hence, if he earns 3.5% a year in his savings account, then this translates into 2.8% after tax (because 2.8 divided by 0.8 is 3.5). So, if he can earn more than 3.5% a year in a taxable savings account, then it makes sense to park his money there instead of overpaying his mortgage.

Of course, a quick glance at the Fool's savings search engine reveals scores of accounts paying more than 3.5% a year before tax. Even better, by saving inside a tax-free cash ISA, my relative can hold onto all of his savings interest and keep the taxman at bay.

My guess is that most mortgage borrowers paying a yearly interest rate of, say, under 4% would be better off sticking their spare income into a top-paying savings account. It all depends on your mortgage rate and your rate of personal tax. Here's how to work out whether it's better for you to save or hack away at your home loan:

For non-taxpayers (and taxpayers who haven't used up their yearly ISA allowance of £3,600)

If you can find a before-tax savings rate higher than your latest mortgage rate, then put your money in this savings account. For example, savings interest of, say, 4.5% a year is preferable to a mortgage charging, say, 3.5% a year.

For basic-rate (20%) taxpayers who have no ISA allowance remaining

Take your savings rate and multiply it by 0.8 (this is the same as taking off 20% tax). If this figure is greater than your mortgage rate, then saving wins. For example, savings interest of 4.5% a year x 0.8 = 3.6% a year after tax, which beats any mortgage charging under 3.6% a year.

For higher-rate (40%) taxpayers who have no ISA allowance left

Top earners pay twice as much tax on their savings, which means that they end up with only three-fifths (60%) of their interest. In this scenario, you should multiply your savings rate by 0.6 (to subtract the 40% tax). For example, savings interest of 5% a year x 0.6 = 3% a year, which beats any mortgage rate under 3% a year.

In summary, my advice is to track down a table-topping savings account (or, even better, a tax-free cash ISA). After subtracting the relevant tax, compare this post-tax interest rate with your mortgage rate. In many cases, you will find that saving makes more sense!

More: Find superb savings accounts and marvellous mortgages | Hunt Down The Best Savings Rates | Beware Of This Tracker Mortgage Trick