With interest rates elevated and the number of UK mortgage deals shrinking on a daily basis, many borrowers are seeking to shore up their finances by paying down their home loans early. However, just because you can doesn’t mean you should.
In just the past week, HSBC Holdings Plc and Banco Santander SA have both suddenly withdrawn several mortgage products, while National Westminster Bank Plc, Halifax, and Nationwide Building Society have all hiked their fixed-rate deals. As of last week, a typical two-year fixed rate deal on a 75% loan-to-value mortgage was 5.24%, compared with barely 1% as recently as September 2021. So does it make sense to reduce your outstanding mortgage balance by overpaying the principal?
The problem with using spare cash to pay down a mortgage is that you typically cannot draw the money back in the event of a crisis. Dipping into your emergency stash to trim your borrowings can significantly reduce your financial flexibility. Most advisers suggest that you should have sufficient funds to cover between three and six months of expenditure, to insure against unforeseen circumstances.
Instead, it might be better to accumulate any surplus in a savings account. In previous interest-rate cycles, it was pretty difficult to keep opening and closing savings accounts to track the best deals. These days, online platforms make staying competitive much easier. You deposit your money with any one of roughly half a dozen different providers and are then free to seek the best deal on the platform at the click of a mouse. The best three-month deposit accounts pay close to 4.75% and a six-month term deposit offers about 5%, both comfortably above the Bank of England’s 4.5% interest rate.
If you’re looking to refinance an expiring fixed-rate mortgage deal, you have two further options to soften the blow of rising rates. You could pay down just enough of your mortgage to drop into a lower LTV bracket. According to property portal Rightmove Plc, a typical 95% LTV five-year fixed-rate mortgage costs 5.50%, but that drops to 5.22% at the 90% category. That might be worth aiming for if you are just above the threshold.
Alternatively, an offset mortgage allows you to retain personal liquidity while reducing monthly payments. The products “offset” savings you have with your lender against money owed on your mortgage. Instead of being paid interest on your savings, which might be taxable, you save interest on your mortgage, which is more tax efficient. An additional advantage, compared to simply prepaying a mortgage, is that any cash you hold in your offset savings account is available to be withdrawn should the need arise — an efficient means of making your emergency cash work harder.
The decision of whether to draw down longer-term savings is trickier, especially for younger workers. As I wrote last week, interest rates are typically lower than inflation, while stock market returns historically are higher. The young are often able to sit out the stock market’s inevitable ups and downs to benefit from the inflation-busting returns typically achieved by equities over the long haul.
However, if your spare cash has simply been languishing in an uncompetitive Individual Savings Account for many years, using some of it to pay down your mortgage might be the least bad option. Cash ISA providers are notoriously poor at continuing to offer competitive rates once they have snagged your savings. Even allowing for their tax advantages, cash ISAs frequently return less than the major savings platforms.
Workers aged 55 or over have an additional alternative to paying down their mortgages. Once they reach that age, it becomes possible to access money paid into a private pension. Younger workers may balk at locking money up for several decades, no matter what the tax advantages. Over 55s, though, need to have no such scruples. A worker paying 40% income tax could see a £60 ($75) contribution grossed up to £100 with tax relief. If cash was then needed in a hurry, £25 could be withdrawn tax-free pretty much immediately, still leaving £75 in the pension plan, which is more than was initially contributed.
The situation is even better for older workers earning more than £100,000 but less than £125,140. Between those two thresholds, in addition to paying 40% income tax, your personal income tax allowance is withdrawn at the rate of £1 for every £2 earned. Effectively this raises your marginal tax rate to 60%, which means you also get 60% tax relief for making additional pension contributions rather than paying down your mortgage.
If you do end up withdrawing cash from your pension to meet an unforeseen short-term emergency, however, it would be wise to take financial advice. If you withdraw more than your 25% tax-free cash sum, that limits your ability to top up your pension again should your financial position improve. Moreover, if you have expensive consumer or credit card debt, that should be cleared first before prepaying your mortgage or making additional pension contributions.
Even if you are worried about your mortgage, your job, or both, throwing all your spare cash at paying down your mortgage might not be the best option. Instead, a combination of the above strategies might allow you to sleep peacefully in your home while protecting you from any unforeseen financial calamity.
A message from Advisor Perspectives and VettaFi: To learn more on this and other topics, check out our full schedule of upcoming CE-approved virtual events.
Bloomberg News provided this article. For more articles like this please visit
bloomberg.com.
Read more articles by Stuart Trow
