I have a flexible reserve (Legal & General, now administered by Northern
Rock) mortgage with 6 years to run, outstanding balance 18k, currently
5.55%. Am I right in thinking that to pay it off I am effectively avoiding
tax on the interest I would otherwise earn on the 18k, i.e., I would need
to find a savings return of some (5.55 x 100/80)%, = 7%? Any views on the
best course of action (including a compromise) very welcome.
Using savings to pay off debt is usually a good idea (unless it's 0% credit
card debt!), but be sure you will not need those savings, as whilst paying
off mortgage is normally simple, getting the money back should you need it
for a rainly day, could cost you in arrangement fees.
Short answer: Yes.
It's a bit of a waste of the flexible reserve facility not to take
advantage of it. So it might be better to stick the money into the
available reserve instead of paying the whole loan off and redeeming
the mortgage early, except that they'll probably require you to have
a minimum principal balance outstanding of £500 or £1000. You need to
ask them to reduce the Actual Payment to £1000x0.0555/12, otherwise
they'll keep taking what they took before and as soon as the balance
drops below their redemption threshold they'll just redeem. But if you
know you won't need to borrow the money back over then next 6 years
you may as well just redeem now and be done with it.
If the mortgage loan is interest-only, you would obviously be saving
£18k x .0555 x 6 = £6k in loan interest over the next 6 years, whilst
if you stuck the cash into a deposit account at 4.8%, you would earn
£4566 in credit interest (that's ((1+0.8x0.048)^6-1)x£18k). Clearly
you'd be £1434 better off paying off the loan, and that's not counting
interest earned on the saved interest.
But if it's a repayment mortgage, probably costing £294.50 a month,
you'd expect to save only £3204 in loan interest over the period (that's
£294.50x72-£18k), and it might at first sight be better to go for the
deposit. But that's a mistake, because it assumes the availability of
an external income stream to fund the principal repayment. Technically,
to be fair, you would need to fund the difference bewteen the £83.25
interest-only loan payments and the £294.50 repayment payments by
depleting the savings principal, which in turn would reduce the amount
of savings interest earned, by almost half.
Bottom line: You're always better off with the higher rate, except
where it's important to retain liquidity.