Archived article

Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.

We run the numbers to compare the different scenarios
Thursday 04 Oct 2018 Author: Laura Suter

You find yourself with spare cash at the end of the month – are you better off saving the money or using it to pay down your mortgage debt? 

It’s the question that homeowners are faced with: to save a pot or relieve themselves of debt sooner. Typically the adage is to pay down any debt before you save money, but mortgages are often considered different to typical debt. Here we attempt to answer the conundrum.


Firstly, if you have money to spare each month you need to make sure that you use it to pay off expensive debt, such as clearing credit card bills or store cards charging high interest rates.

Once you’ve cleared that – or if you didn’t have any debt in the first place – you then need to build up a cash buffer to cover your expenses if an unexpected event happened, such as illness or losing your job.

The rule of thumb is to have between three and six months’ essential expenses covered, such as your mortgage, heating and food bills.

Assuming you’ve sorted all of this, you then face whether it’s better to save or make extra payments towards your mortgage. In part, it really depends on what you are hoping to do with your savings.

If you have a particular goal that you want to achieve, such as buying a new car in two years because yours is going to conk out, or saving for school fees when your child starts their education in three years’ time, then you are probably better off saving money for that, rather than locking it up in your mortgage.

If you’ve already met those savings goals – or you’ve got spare cash even after saving for them – then you can consider overpaying your mortgage.

First, you need to check that your mortgage company allows you to overpay some of your mortgage. Most will allow you to repay up to an extra 10% of the mortgage amount each year, but anything above this may result in an early-repayment charge that often makes it cost prohibitive. 

Some, such as Tesco Bank, allow you to repay 20%, while others allow unlimited repayments (although these are rare and you may end up paying a higher interest rate on your mortgage in return for this flexibility). Definitely check whether your mortgage company allows early repayment, and how they calculate the 10% figure.

Another important factor to check is that your repayments go towards reducing your mortgage debt, rather than reducing your monthly payments.


Whether you’re better saving the cash and investing it depends on your mortgage rate. Rates are at historic lows at the moment, making borrowing incredibly cheap for homeowners. The actual rate you pay depends on the amount you borrow versus the value of your home (or your loan-to-value ratio), your credit rating and whether you have shopped around for a better rate. 

We’ll assume you are a savvy homeowner who has locked in a low rate. For a £200,000, 20-year repayment mortgage on a £250,000 property you would pay around 2.2% for a five-year fixed rate or 1.5% for a variable rate, which rises when the Bank of England’s base rate increases. 

We’ll also assume that your provider allows you to repay 10% of your mortgage amount each year – starting at £20,000 – and that by doing so you cut your mortgage debt, not your repayments.

After seven years (with the above £200,000 mortgage and assuming a constant interest rate of 2%) you could have reduced the mortgage balance to £63,715 via the overpayment route.

We assume you have budgeted £20,000 each year for the overpayment, even though the mortgage overpayment amount will decrease each year as you’re paying 10% of the outstanding balance – so you pay less as the mortgage balance falls. For example, in year two you pay £17,179 and then £14,710 the following year.

Any unused money from your £20,000 annual budget is put in a cash savings account each year earning 2.5% interest. After seven years this cash balance plus interest is worth £67,010. This money is used to clear your mortgage (and we assume you don’t have to pay any early repayment charge).

This would cut 13 years off your mortgage term and would save you £27,743 in interest payments, compared with a scenario where you made no overpayments.

Any cash you would normally have used for mortgage repayments could, from this point, go towards your pension or other savings.


What do you end up with if you’d invested the entire mortgage overpayment money instead? Determining the return you’re likely to get from investing is tricky, and depends on how risky your investment is and how long you’re invested.

On average, according to Barclays’ Equity Gilt study, you can expect to get returns of 5.6% over the long term from the stock market – although this figure is ‘inflation adjusted’ and so is lower than the headline figure would be.

If you invested that same £20,000 each year, assuming
an annual growth rate of 5%, you would end up with just over £167,000 at the end of the seven-year period you would have been overpaying on your mortgage.

This would be made up of deposits of £140,000, with around £27,000 of interest on top. In this scenario you would have been slightly better off overpaying on your mortgage, as the interest saved on the mortgage is greater than the money generated by investing.


If you were willing to put the money in higher risk investments, and we assume a 7% return, you would end up with almost £180,000 at the end of the same period – with £40,000 of that being profit. In this scenario you would end up more than £12,000 better off by investing.

However, investing clearly involves some risk, and you could lose money during this period. If you were more risk averse and wanted to deposit the money in a bank account you could expect to get around 2.7% at the moment on a five-year fixed-rate bond. Assuming this as a constant rate for the seven years, you would have just over £154,000 – a £14,000 gain and so you’d be worse off than overpaying your mortgage.


What about if you hedged your bets and put half the money into your mortgage and half into investments? By overpaying by £10,000 a year on the same mortgage scenario as above you’d end up paying off your mortgage after 10 years, and would save £21,060 in interest.

Alongside that, your £10,000 annual investment would generate £29,160 profit at a 5% rate after 10 years, or £43,349 at a 7% annual return. Because the money is invested for longer, the returns are compounded for longer, significantly boosting your pot.

By taking this approach you’d end up around £8,000 better off in the 5% investment scenario, or £22,000 better off at 7% returns. It’s worth noting that because you’re paying in for 10 years you need to put in more money than in the previous scenario.


It’s fair to assume that even after you’ve paid off your mortgage, you’re going to have cash to spare that you could save and invest. So what about if we worked the figures out over
20 years?

Someone who saved that £20,000 a year over 20 years would end up with a pot of £679,000 assuming a 5% rate – having earned £279,000 profit. At a 7% interest rate this would rise to £450,678 profit. In the cash scenario they would have generated £129,000
of interest.

If that same person had spent the first seven years overpaying their mortgage, and ultimately paying it off, and then invested the cash, they would have profit of £103,783 at a 5% rate, or £157,929 at 7%. In the cash scenario they would have £51,051 interest.

If you add that to the £27,743 you would have saved in mortgage interest by paying off your mortgage early, you still don’t come near the returns from the investment scenario. 


Cut your term – If you’re certain you won’t need that spare cash for anything else, you could consider shortening your mortgage term next time you remortgage. By doing so your monthly repayments will increase and you are effectively permanently overpaying on your mortgage and cutting the total interest you pay. This relies on you knowing that you won’t need access to that money for anything else.

Use an offset mortgage – An offset mortgage counts any money you have in an associated savings account against the amount you owe on your mortgage. This effectively reduces your outstanding loan, but still gives you the flexibility to access the savings money if you need it. Fewer providers offer offset mortgages and you are likely to pay a higher mortgage rate in return for
the flexibility. 

Laura Suter, personal finance analyst, AJ Bell

‹ Previous2018-10-04Next ›