Money Q&A: Pay off the house or hold on to the cash?

My wife and I are currently in a dilemma over whether to pay off some or all of our mortgage (on a house worth pounds 112,000). We are both in our early 30s. I have been building up pensions since the age of 18 including, more recently, additional voluntary contributions. My wife has no pension provision and stopped work six years ago when we started a family. We have various PEPs, shares and building society accounts worth pounds 52,000. We have life cover of pounds 85,000. As the only wage earner, on a salary of pounds 23,000, paying off the mortgage would give me peace of mind. On the other hand we may want to use the money for private education.

DA, Warwickshire

You are young parents with young children, a mortgage and (no disrespect) a less than astronomical salary. Yet you are in the sort of position that could make many of your peers green with envy.

Over recent years some financial experts have said that paying off a mortgage is one of the best and safest "investments" you can make in terms of the return you get. But the case for clearing a mortgage debt may be less strong at a time when interest rates are low and look set to remain so. You need to look at how the cost of borrowing compares with the return from investing your money. And you need to take a view on likely future borrowing costs and investment returns.

For example, you may be paying about 7 per cent on your mortgage. Remember that until the abolition of mortgage tax relief next year the true cost is a bit less than 7 per cent on the first pounds 30,000 of your loan. Compare 7 per cent with the after-tax return you get on your savings and investments. Some investments (Tessas and the new ISAs - individual savings accounts) are tax free.

Stock market investments are harder to call. What is the likely total return - ie, dividends plus changes in capital value? What is the likely total return after income tax and, possibly, capital gains tax? If you think you can get a total after-tax return of, say, 10 per cent against a mortgage cost of 7 per cent then you will make a net 3 per cent on your money.

Before deciding to clear the mortgage, find out whether there are any penalties. If you opt for partial repayment check whether this will have an immediate effect on the interest you are charged. With some lenders, repayments do not register on the outstanding balance on which interest is charged until the end of their financial year.

Before paying off the mortgage, take account of any spending plans on the horizon. Investigate the likely costs of private education. If you are likely to need to take out a personal loan at some time, it may be best to hold some money back rather than pay off the mortgage. Mortgages are one of the cheapest ways to borrow money.

Finally, the one weakness in your otherwise strong financial position is that your wife has made no pension provision. In fact she cannot pay into a formal pension plan with all the associated tax perks unless she has relevant earnings from employment or self-employment. If you pay off the mortgage you should keep your endowment policy going until maturity in order to get full value from it. Maybe you should consider the endowment policy as essentially belonging to your wife to make up for her lack of a pension.

Student saver

Our 18-year-old son is going to university in October. We will be able to offer him most of the financial support he is likely to need but he will probably have to take out a student loan of about pounds 1,000 a year for his four-year course. Nevertheless, he is interested in getting into the savings habit and would like to set aside pounds 10 a month in a medium-to-long- term savings plan maturing in, say, 15 to 20 years' time. Does this make financial sense given he will leave university with a debt? And if it does, where should he save? I have had some 25-year with-profits insurance policies which will give excellent returns, but I am told these are old- fashioned.

CM, Manchester

It rarely makes sense to save money if you also need to borrow. Borrowing usually costs more than the return on savings. However, the interest rate on an official student loan is the inflation rate, and borrowing does not come much cheaper than that. Also, there is a long delay before the loan has to be repaid. And you could argue that getting into the savings habit at an early age may provide long-term financial benefits that outweigh any short-term costs.

But what if your son needs to borrow more than he is allowed to borrow in the form of an official student loan?

Students are notorious for getting into debt - and you do want your son to have a good time at university outside his academic studies. Even preferential overdraft rates and other loans for students don't come cheap.

If your son does decide to squirrel away some money, he should retain some flexibility. He may want to repay debt soon after graduating, or he may need a deposit for a flat (although pounds 10 a month is not going to produce a big lump sum over four years). A deposit-based individual savings account would probably be the best option. He may not even need this if he is a non-taxpayer but he has nothing to lose with an ISA. And he could become a taxpayer while a student if he finds lucrative holiday work.

Be wary of with-profits policies. The costs can be disproportionately high on small premiums and returns on these policies have been falling fast.

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