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shadows of echoes of memories of songs
Don't shop me now
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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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