Should you build up your savings or repay your mortgage?

What's best, putting money away in a savings account or over-paying on your mortgage? With both savings and mortgage interest rates at an all-time low, Tim Bennett says it's no contest.

Borrowers on low tracker rate mortgages should not be overpaying their mortgages but investing surplus cash in a savings account instead, says the Sunday Times. But this is a bad idea.

A recent survey from the Co-operative Bank suggests that 80% of people overpaying on their mortgage while interest rates are low believe they are better off.

They are dead right. If you pay, say, £300 a month towards a mortgage when interest rates are high, very little of it is used to pay off the original capital you borrowed. Instead, most of your £300 will simply service the interest cost.

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However, pay £300 a month when rates are low - a 2007 Woolwich lifetime tracker charges just 0.67% for example - and most of your money is used to reduce your outstanding debt. This makes perfect sense because should interest rates rise in the future, as many expect, your mortgage will be more manageable as a result of your overpayments.

However the banks, aided by the Sunday Times, would have you believe otherwise. So desperate are they for your cash that some are urging borrowers to reduce their mortgage payments and open a savings account instead. This is madness.

First off, interest on savings is taxable, but you pay your mortgage interest from your post-tax income. So overpaying your mortgage is tax efficient. For example, if you choose to service your mortgage interest of say 0.67% from savings account interest of 5%, you have been taxed twice. Once on the post-tax salary you paid into your savings account. And a second time on the interest you earn on any deposit. Daft.

Secondly, you are doing the bank, not yourself, a favour. And who wants that? The reason is that by paying your surplus cash into a bank account you are helping them boost their capital. And you are also stretching the amount of time it will take to clear your mortgage, raising the prospect of them being able to charge you more interest in the future as mortgage rates rise.

So, I recommend you do the exact opposite of what the Sunday Times suggests.

One of the best ways to reduce mortgage interest if you have surplus cash - which you may for example have set aside for "rainy day" emergencies - is with an offset account. Here your savings of, say, £10,000 are netted off against your mortgage of, say, £100,000. The net balance of £90,000 is what you pay interest on. You can also get your current account balance offset against the debt too.

Try for the best offset rates.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.