Should you use your savings to pay down your mortgage?

When we did the live webchat for viewers after the second episode of Superscrimpers (a Channel 4 series on personal finance which I’m co-presenting) one of the most-often asked questions was about mortgages and savings. If you have both should you use the savings to pay down your mortgage? Or should you hang on to the cash?

The obvious answer is to make sure you have six months’ worth of living money in a good instant access savings account and use the rest to pay down your mortgage as fast as possible. Why? Because it will save you a fortune in cash.

Say you have a mortgage of £150,000 on a rate of 4% with 15 years left to run and £20,000 in extra cash. If you keep the mortgage at £150,000 and keep making your monthly payments (which will be about £1,110) your total interest bill for the 15 years will come to £49,715. But pay it down now to £130,000 and that comes down to £43,000.

So you’ll save £6,700 – and even more if you keep your monthly payments at £1,110 rather than dropping them to reflect the falling debt. Do that and you will knock two years off your mortgage term and save another £6,000 in interest along the way. So a total of not far off £13,000 saved in interest payments. You can calculate all these numbers with reference to your own mortgage here.

Obviously if you’d kept all the money in a savings account this would have been offset by the interest you would have received on it. But odds are this wouldn’t have been as high as the interest rate on your mortgage. You would also have had to pay tax on it.

So clearly in a rational world, paying down your mortgage is the right thing to do. But we aren’t all entirely rational about money: many of us are loath to lose control of our cash by putting it into our mortgage. We’d rather keep it where we can get at it – regardless of the long term costs.

However all is not lost. For these people there is the offset mortgage. These sound complicated. But they really aren’t. All you do is hold your mortgage and your savings in the same account. That way the money in your savings account is ‘offset’ against your mortgage. This means that you won’t earn any interest on your savings, (and you won’t be paying any tax), but you won’t be charged any interest on the same amount of your mortgage either.

This can save you a fortune over the full term of a mortgage. An example from Scottish Widows. Say you have a 25-year £130,000 mortgage with a monthly payment of £824.44 and £15,000 in savings. If you offset the £15,000 you will cut three years and 11 months off your mortgage term and save yourself £38,763 in interest. And best of all you will retain full access to your cash: if you need the money you can just withdraw it.

It used to be that offset mortgages came with higher interest rates than ordinary mortgages. This is no longer really the case: according to Moneynet, the rates are now on average only 0.36% higher than ordinary rates and some lenders charge only 0.1% or so more. That makes the offset mortgage a very attractive option indeed. Think of it as the best of both worlds.