The Mortgage Clinic: 'Should I build up savings or clear my debt?'

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The Independent Online

Q. I have a fixed-rate mortgage, with a 25-year term, and I'm making overpayments each month so that I can pay it off early. However, the rate I am paying is under five per cent and several savings accounts, especially ISAs, are paying more than that. Would I be better off putting the money into an ISA each month?

JC, Middlesex

Making overpayments is a good way to save money on the mortgage in the long term. Although the amount you pay out every month will be higher, the capital is paid off more quickly. This cuts the total interest bill.

However, if you can earn more on a savings account, it makes sense to divert the overpayments into that. "If the returns on a savings plan are higher than those charged on a mortgage, then it makes financial sense to use the savings account," says Louise Cuming, head of mortgages at moneysupermarket.com. "If the situation changes, the lump sum in the savings account can then be used to reduce the mortgage."

But she cautions that it is important to check that the interest earned really will be higher than the interest charged on the mortgage, especially after tax.

Unless you can take out a tax-free cash ISA - which has an annual savings limit of £3,000 - then you will pay tax on any savings income. A basic-rate tax payer will receive 78 per cent of the "headline" rate on an ordinary savings account. A higher-rate tax payer receives just 60 per cent.

It is also important to check the exact terms of the mortgage. With some mortgages, it is OK to make lump sum overpayments. For fixed-rate loans, the limit is typically 10 per cent of the mortgage in any one year.

Some lenders have different rules. Nationwide, for example, allows borrowers to overpay £500 a month, regardless of the size of the mortgage, on its fixed-rate loans. This makes diverting the money into a savings account first less practical.

However, if you suspect you will need access to the money in the future, paying it into a savings account now could still be the best option.

"Most fixed-rate mortgages are not flexible, so once an overpayment has been made, it is not easy to 'borrow' the money back," cautions Louise Cuming. "Committing overpayments or capital repayment to a mortgage comes with a health warning: you must be sure you are comfortable that you will not need the funds for a rainy day."

In the future, if you think you might need this type of flexibility it is worth considering an offset mortgage.

Confused about your mortgage options? Foxed by jargon? E-mail mortgageclinic@independent.co.uk

NB: we will not reveal your identity, and we cannot give specific advice

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