Saving spare cash beats repaying cheap debt

Published 20th Jul 2009

Rising savings rates are increasing the appeal of holding spare cash on deposit rather than paying down cheap mortgages.

Building up cash reserves instead of repaying low-rate debt also makes sense given ongoing economic uncertainty and tight credit, said advisers.

Fixed savings deals increased again this week, with top rates of 5.4 per cent now available from Yorkshire Building Society on a five-year bond and 5 per cent for a three-year term. One-year bonds are paying up to 3.85 per cent while variable-rate deals offer about 3 per cent.

Meanwhile, about 1m homeowners are paying loan rates of just 2 per cent or less, according to John Charcol, the mortgage brokers. Most are on base rate tracker deals taken out a year or more ago, the costs of which have dived as the base rate has dropped to 0.5 per cent. Borrowers with these loans can therefore earn a higher return on cash savings – even after tax on the interest – than the cost of their loans.

This opportunity – termed an arbitrage – could make some borrowers thousands of pounds. “This is a way for some borrowers to get their cash working harder [than paying down their mortgage],” said Adrian Lowcock, senior investment adviser at Bestinvest. “This interest rate arbitrage comes and goes, but it’s more pronounced now because the base rate is very low while banks still need deposits.”

The opportunity runs counter to conventional wisdom to pay down debt with spare cash – a view which reflects that interest rates for borrowing are typically higher than the after-tax returns available from savings accounts.

“Very few borrowers think about arbitrages – they just want to pay down their debt. But it can be a [financial] ‘no brainer’,” said Ray Boulger, senior technical manager at John Charcol.

Paying down a mortgage reduces future interest costs and is equivalent to earning the rate on that loan.

But putting cash into a higher-paying savings account offers an extra return that can then be used to further reduce the debt – allowing borrowers to pay off their mortgages sooner.

For couples, it makes sense to hold the savings in the name of a partner who is in a lower tax band or is a non-taxpayer to achieve the best return on the cash account.

Tax-free individual savings accounts (Isas) can also offer low-rate borrowers a higher return than the cost of their mortgage.

In addition, having a savings cushion offers flexibility for borrowers whose jobs may be under threat. “Everyone needs some rainy day cash but it’s also worth keeping a lump sum on hand because you can no longer assume you will be able to borrow money,” said Boulger.

David Black, banking consultant at Defaqto, the research company, added that individuals who paid off some of a low-rate mortgage may find they are charged more if they want to borrow that money back.

However, with most low-cost mortgages tracking the base rate, arbitrage profits could disappear as rates rise, while many borrowers will also be on deals that revert to a higher rate in the next couple of years or so. So experts warn against tying up savings for too long.

Boulger said two-year savings bonds paying more than 4 per cent could be a good bet for low-rate borrowers, given that the base rate was unlikely to rise until next year.

By contrast, when the base rate rises again, it could shoot up, so a longer-term 5 per cent bond might mean earning less than future borrowing costs, warned Black.

Experts also said that for borrowers with high loan-to-value ratios, it may still be worth paying down cheap mortgage debt to help gain access to the best new loan deals.

Source: ' FT '

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