A home for your cash

Mike Goodman looks at the arguments for paying off some of your mortgage debt
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The Independent Online
YOU WON'T see much advertising urging you to use maturing Tessa money to reduce your mortgage. But for many people that may well be the best use for their money. And that's despite the latest cuts in mortgage rates and the Budget cut in savings tax.

The strongest argument for this choice is simply that of cutting into the mortgage millstone. Those who already have a reasonable savings cushion may prefer less debt, and the reassurance of owning more of their home, to bigger savings.

There should also be a rapid improvement in cash flow; most lenders will cut mortgage payments from the next month.

When tax rates were higher and mortgage tax relief more generous, the benefits of using lump sums to cut borrowings were less attractive. Before 1988, higher-rate taxpayers enjoyed 60 per cent relief on their interest on the first pounds 30,000 of their mortgage. It was more tax effective to keep the mortgage the same and invest spare cash in, say, a pension plan, which also attracted 60 per cent tax relief.

Now mortgage relief is a measly 15 per cent for all taxpayers on interest on the pounds 30,000. Taking into account the latest cut in mortgage rates to 7.49 per cent, every pounds l0,000 paid off the capital would save up to pounds 62.40 per month on an interest-only mortgage. If the debt is below pounds 30,000, the saving is less - pounds 53 a month - because of the forgone tax relief.

That same pounds 10,000 invested in the building society would be hard put to earn as much in interest. Banks and societies have to make a profit, so they always pay less overall to savers than they charge borrowers. New fixed-rate Tessas might be quoting 7.5 per cent in interest, but they are the exception and the offers might not last.

Tax will reduce the return significantly on other accounts, even with just 20 per cent savings tax and particularly for higher-rate payers. And while the tax advantages of personal equity plans might seem attractive, people will need to decide whether they feel more secure with less mortgage debt than with the ups and downs of the stock market. In particular, if interest rates soared, mortgage payments would rise, while a PEP might struggle to perform.

To gain maximum benefit from a lump-sum payment, borrowers should make it clear to their lender that it is a one-off capital repayment, rather than simply mortgage instalments paid in advance - called overpayments. If you do not make it clear, the lender will not reduce the overall debt straight away - potentially not for a year. In effect, borrowers will then be making an unintentional interest-free loan to the bank or society.

Most lenders will accept one-off capital repayments of as little as pounds 500, credit the sum against the outstanding mortgage within days, and reduce payments from the following month.To get maximum benefit, put the money in just before the next monthly payment is due, while taking account of how long the lender will take to clear the cheque.

The bank or society should be able to give details of the optimum date and any other catches, such as if the capital debt is not adjusted straight away.

Some lenders will shorten the term of a repayment mortgage rather than cut monthly payments if the borrower makes a part redemption.

Importantly, before part-repaying mortgage capital, borrowers should check if they are subject to what are called "redemption penalties". For mortgages taken out in recent years which included a special fixed discount or cashback offer, there will almost certainly be a penalty for early part-redemption. Some may last for up to seven years. But Citibank, for one, will waive penalties if the borrower is trying to clear negative equity, and there are several other lenders which will treat such cases sympathetically.

Ian Darby, of mortgage broker John Charcol, warns borrowers not to sink every penny from maturing Tessas into part-paying off a mortgage. It is harder to reborrow the money again on a mortgage should it be needed elsewhere.

Borrowers should clear other, more expensive debts first - such as credit cards. And there should always be enough money for emergencies, such as car or house repairs.

Borrowers who have just lost their jobs should think carefully about paying off some of their mortgage with Tessa money (or redundancy pay). They are not eligible for housing benefit if they still have savings of more than pounds 8,000, and there is a sliding scale means test between pounds 3,000 and that figure.

Meanwhile, for borrowers with negative equity, a one-off mortgage capital payment may lift them out of the trap and enable them to move at a future date.

Additional reporting by Steve Lodge.