The best home for your money is your mortgage

Should you use your savings to pay down your mortgage debt, or should you put your spare cash in a tax-free savings account?

Received wisdom

In the 'normal' world we used to inhabit before banks had to be bailed out and one penny mortgages became a reality, received wisdom was that since debts are usually charged at a higher rate of interest than you can earn on savings, you should get rid of your debts before starting to save.

But mortgages are a grey area. Many people have only recently become aware that they can overpay their mortgage, which reduces your debt and therefore the interest you are charged. This can potentially cut years off your mortgage term saving you thousands of pounds, as I explained in Cut years off your mortgage.

But is this strategy still the best option with mortgage rates so low, especially with some (relatively) tempting ISA deals around? OK, the current tax-free savings rates are not going to knock your socks off, but many are higher than some mortgage rates.

This could mean it's better to save your money in an ISA, rather than pay it off your mortgage. But how do you work out which is going to see your money work harder for you, and are there any other factors to consider apart from just number-crunching?

Do the math

Firstly, you need to know your mortgage rate and the ISA rate you are thinking about. Now it's simple. Which is highest?  That's where your money will work hardest for you.

So, if your mortgage is currently 5% and the best ISA you can find is 3% your mortgage debt is growing more quickly than your savings can. From a purely mathematical point of view your money will work harder for you going towards overpaying your mortgage.

If you are lucky enough to be on a tracker mortgage and your rate is now very low, say 2%, it's possible you could find an ISA paying interest at 3%. So you would be better off saving your money in an ISA as it would increase more quickly than your debt will increase.

But it isn't as simple as working out the highest rate.

If you wanted to get really technical you could also work inflation into your sums, but given that inflation is either currently 0% if you believe the Retail Prices Index, or expected to fall sharply if you follow the Consumer Prices Index (currently 3.2%), I think it's reasonable to proceed without spending too long assessing its impact.

But there are other factors.

Not only numbers

If you are thinking of putting your money into an ISA because your mortgage rate is so low, remember that unless your mortgage rate is fixed, there is potential for it to rise.

The Bank of England Base Rate is just 0.5% and even if it is cut again, after that the only way is up. If your mortgage rate is variable, you can be sure that when Base Rate starts to rise your lender will start to pass on the increases (and with more gusto than your ISA provider will). In other words, consider the possibility that your mortgage rate could be higher than your ISA rate by the end of the year.

Mind you, this would not be a problem if you choose an instant access ISA and are happy to switch your money out of it and into your mortgage as soon as becomes a better option. But check the details of any ISA to ensure this is possible.

The LTV issue

Another thing to consider if you are thinking of saving your extra cash rather than overpaying your mortgage is that reducing your mortgage can offer other advantages apart from the obvious.

Yes, it will reduce your debt and therefore the interest charged and, yes, this could cumulatively save you thousands of pounds and cut years off your mortgage.

But in the current climate, it is equally important to be aware that by reducing your debt you can help to decrease your loan-to-value (LTV) ratio -- your outstanding mortgage as a proportion of your property's value.  If you owe £90,000 on a property worth £100,000, you have an LTV of 90%. But if you pay off £5,000, your debt would drop to £85,000 and your LTV would fall to 85%.

So what?

Well, LTV is one of the most important factors in determining which mortgages you can access. The lower your LTV the more competitive deals you can get. The higher your LTV, the fewer mortgages are available. And over 90% LTV, you will struggle to get any mortgage at all, and could be forced to stay on whatever deal your current lender will offer you, as Jane Baker explained in Why it's vital to overpay your mortgage now.

So paying down your debt could really make the difference between you being able to remortgage or not at the end of your current deal.

Access your cash

However, there is one big reason why putting your money in an ISA might make more sense than overpaying your mortgage debt.

You can access your cash.

The majority of ISAs are instant access meaning you can get your hands on your savings if you need to. This is a major benefit, especially in uncertain times. If you lose your job or your car conks out, being able to access your cash could be a major bonus.

If you have overpaid the money into your mortgage, you may not be able to get it back, unless you have a particularly flexible mortgage deal. Of course you could remortgage to release equity (if you have it) but this will take time.

So, do the math and see whether your money could work harder paying off your mortgage or earning interest in a tax-free ISA -- but consider your personal circumstances too.

And, if you do want to take advantage of this year's ISA allowance (£3,600 for cash ISAs), HURRY! The ISA deadline is Sunday.

Compare mortgages and ISAs at lovemoney.com