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Don't shop me now - shadows of echoes of memories of songs
j4
j4
Don't shop me now
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gareth_rees From: gareth_rees Date: November 30th, 2008 01:52 pm (UTC) (Link)

the limits on how much tax free investment you can have each year mean that you've got a much smaller pot of tax efficient savings in future

Luckily this effect makes no difference to your decision whether to pay down debt or to save—even if you are in the special position of being able to max out your ISA this year but knowing that you will be unable to do so some year in the near future. (In this position you might be considering saving the sum in a non-ISA account until the time comes when you have some spare ISA allowance.)

Suppose you owe x at an interest rate of d, and you have a sum of x to invest, and you are deciding between these options:

  1. Pay off the debt;
  2. Save it in an ISA with an interest rate of s for n years;
  3. Save it in an ordinary savings account with an (after-tax) interest rate of t for m years, then transfer it to an ISA as in (2) for the remaining nm years.

Then (considering only the effect of this one transaction; obviously in real life there would be many other transactions but it's legitimate to consider the net effect of each one separately) after n years you will have, respectively:

  1. Nothing
  2. x(1+s)nx(1+d)n
  3. x(1+t)m(1+s)(nm)x(1+d)n

Since t<s, clearly (2) is better than (3), and equally clearly (1) is better than (2) unless d<s which is almost certainly not the case since interest rates on debt are almost always greater than interest rates on savings.

So the moral is that you don’t need to worry about the complications due to the ISA allowance. Just pay off the debt!

beingjdc From: beingjdc Date: December 1st, 2008 01:36 am (UTC) (Link)
I think I disagree. It's a long time since I was any good at algebra but - when I had a mortgage, I overpaid and treated it as a tax-free savings account.

When I sold up, it left me with a lump of cash that I couldn't put in a tax-free account, it being too large. Whereas if I'd paid interest-only or a little more on my mortgage, and put my overpayments into an ISA during those years, I'd have lost the 0.5% difference for three years (so about £60), due to mortgage interest rate being higher than savings rates, but I would have gained in each subsequent year the benefit of £9000 of investment interest being untaxed rather than taxed, so around £100 a year.
gareth_rees From: gareth_rees Date: December 1st, 2008 08:46 pm (UTC) (Link)

That's a very good point. It's the windfall (the lucky acquisition of £9,000) that makes the difference, because it means that we're considering a different question.

The new question is this. Suppose you owe x at an interest rate of d, and you have a sum of x to invest now, and you confidently expect a windfall of x in w years time, and you are deciding between these options:

  1. Pay off the debt now with the initial sum and invest the windfall in an ordinary savings account with an interest rate of t for nw years;
  2. Save the initial sum in an ISA with an interest rate of s for n years and pay off the debt with the windfall as soon as you get it.

Then after n years you will have, respectively:

  1. x(1+t)nw
  2. x(1+s)nx(1+d)n + x(1+d)nw

So you are better off paying off the debt now if

(1+t)nw > (1+s)n − (1+d)n + (1+d)nw

and to a first approximation (since s, t and d are small) this is the case when

tntw > sndw.

Take a typical example like yours where the debt is a mortgage at 6%, the tax-free savings rate is 5%, the after-tax savings rate is 4%, the windfall comes after 5 years, and we are looking at the outcome in 20 years time, then tntw = 0.6 and sndw = 0.7 so waiting is better. But with other rates and other durations the decision would have gone the other way (for example if the mortgage had been 8% instead of 6%, or if the windfall had arived after 10 years instead of 5). There’s unfortunately no substitute for doing the maths!

So the moral is: if you expect a windfall of money in the future that will exceed your tax-free allowance, you have to think a bit harder. We should all be so lucky!

beingjdc From: beingjdc Date: December 1st, 2008 08:53 pm (UTC) (Link)
The real flaw here is the Government's failure to notice that mortgages are now easily used as a tax-free savings vehicle, and adjust the tax-free savings allowance for non-homeowners accordingly. I have made this point to the Housing Minister :) Well, the previous Housing Minister. I think it was a little lost on her, sadly.
gareth_rees From: gareth_rees Date: December 1st, 2008 09:16 pm (UTC) (Link)
I think it was a little lost on her

It's lost on me, too! Can you explain?
beingjdc From: beingjdc Date: December 1st, 2008 09:19 pm (UTC) (Link)
Say I have £10,000 a year to divide between my housing costs and my savings.

If I rent for £400 a month, I am left with £5,200, on which I can only earn tax-free interest on £3,600. However If I pay a mortgage at interest of £400 a month, I can bung the remainder into overpayments, which will reduce my mortgage interest by the full amount that I would gain from tax-free savings.
gareth_rees From: gareth_rees Date: December 1st, 2008 09:32 pm (UTC) (Link)
I understand your example, but there is an obvious objection to this being an injustice: namely, that your example assumes that £400 rent gets you an equivalent amount of house to a mortgage costing £400 interest. This certainly isn't the case at the moment: houses are priced high relative to rents. Even in a non-bubble market, you'd expect the tax advantage of paying off a mortgage to be priced into the cost of houses.
beingjdc From: beingjdc Date: December 1st, 2008 10:00 pm (UTC) (Link)
They were priced high relative to rents until the Bank of England's latest insanity. Now, our rent is equivalent to a purchase price (at 5% which is available with a decent deposit - existing tracker customers paying less) of £296,000 - on a flat whose twin fetched only £285k last year.
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