So how do you decide which is the best place for your money? Or can you balance paying into both?
Start with a financial check-up
Before deciding what to do with any extra cash, it’s a good idea to make sure your finances are in good shape. A good financial check-up should include:
paying off any high-interest debts - high-interest loans, such as credit cards and overdrafts, usually have expensive repayments. It’s wise to pay these off first, so you aren’t spending lots of your hard-earned money paying off interest;
building an emergency fund - having some money put aside for a rainy day is important. You never know when you’ll need to cover unexpected costs. This should ideally be enough to cover three-to-six months of expenses and kept in a low-risk, easily-accessible savings account; and
paying into your pension - the current full new State Pension is £221.20 per week (2024/25). If you think you might need more than that to sustain your retirement, make sure you’re saving into a private or workplace pension. If you’re not sure how much you need to save, you can use our Pension Calculator. This will help you visualise the savings you have now and how much you’ll have by the time you reach your desired retirement age.
Now your finances are in good shape, we can explore how to get your extra cash working as hard as possible for you. What are the benefits of each option? We’ll cover overpaying your mortgage, saving into an Individual Savings Account (ISA) and investing.
First stop, mortgages.
What are the benefits of overpaying your mortgage?
Paying off a house is the dream for many homeowners. Overpaying your mortgage is one way of getting you there sooner. The benefits include:
repaying your loan faster - the sooner you’re mortgage free, the sooner you can use that money for other things;
reducing your total loan cost - you pay interest on the remaining balance of your mortgage, so the quicker you pay off that balance, the less interest you’ll pay;
lowering your loan-to-value (LTV) ratio - this could help you get a better deal when it comes to remortgaging; and
providing peace of mind - it shouldn’t be overlooked that overpaying can simplify your finances and provide greater certainty.
Check the terms and penalties first
Many mortgages only allow you to repay up to a certain amount, often around 10% per year. If you go over this, you may have to pay an Early Repayment Charge (ERC). This is to make up for the interest your mortgage provider would’ve earned if the loan had been paid off on schedule.
You also need to make sure you’re reducing the term of your mortgage, rather than reducing your repayments. This will ensure you have less interest to pay overall and help you pay off your mortgage faster.
Now let’s look at ISAs.
What are the benefits of saving or investing in an ISA?
ISA stands for Individual Savings Account. Every UK resident over 18 has an annual ISA allowance of £20,000 for 2024/25. ISAs come in several varieties, but all are free of both income tax and capital gains tax (CGT). This makes them a tax-efficient way for you to save or invest.
In total there are five different types of ISA. We’ll focus on the pros and cons of Cash ISAs and Stocks and Shares ISAs.
Saving into a Cash ISA
There are several types of Cash ISAs, but all provide a rate of interest on any money you save in them. Their benefits include:
offering a low-risk way to save - your savings earn interest paid for by the ISA provider. This makes them ideal for those looking for certainty; and
providing easy-access to your savings - if you choose an easy-access Cash ISA, you can withdraw your cash at any time without penalty. This makes them ideal for your emergency fund.
But they’re less suited to long-term saving.
Once you’ve built your emergency fund Cash-ISAs might be less beneficial. They usually have low interest rates, so you’ll often - but not always - save more by overpaying your mortgage, or investing. Try a Mortgage Overpayment Calculator to help you compare which option is best for you.
Investing into a Stocks and Shares ISA
A Stocks and Shares ISA allows you to invest in funds, bonds and company shares. Its benefits include:
potentially growing your wealth - depending on what you’ve invested in, your investments can grow in value. Shares can pay out a dividend, bonds can earn interest and both assets can appreciate - and depreciate - in value over time; and
compounding - effectively where you earn returns on your returns. Like a snowball rolling down a hill, the longer you leave it, the higher your returns could be.
But be aware of the risks.
If you decide to invest in a Stocks and Shares ISA, keep in mind that investing always carries a degree of risk and returns aren’t guaranteed. You may wish to only invest money you can afford to lose, as investments can drop as well as increase in value. A good rule of thumb is to invest money you don’t need to access within the next five years. This will give you time to ride out possible market volatility.
ISA vs. mortgage - which is best for you?
Saving, investing or overpaying your mortgage are all valid uses for your spare cash, depending on your circumstances. Here’s a summary:
overpaying your mortgage - this option helps you repay your mortgage sooner and offers guaranteed, predictable savings. This means it’s a particularly valuable option for those looking for predictability and greater peace of mind. Just be aware of potential Early Repayment Charges.
saving into a Cash ISA - this is considered to be a low-risk way to save. The easy access it provides makes it a great place to build your emergency fund. Pay close attention to the interest rates however. Once your emergency fund is built, other options could provide a better rate of return.
investing in a Stocks and Shares ISA - this offers the potential for growing your wealth, but comes with risk. To fully enjoy its benefits, it’s best to keep your money invested over the long term. You’ll also need to keep a close eye on your investments to make sure they match the level of risk you’re comfortable with.
Of course, a blended approach could work better for some. You could allocate a portion of your extra funds to overpaying your mortgage and the remainder to investments. This approach can help you reduce your mortgage repayment time while also growing your long-term wealth.
What about pensions?
Of course, pensions are a key component of any long-term financial plan. They’re a tax-efficient way to save for your retirement and the sooner you start, the more your pot will grow. To better understand how much to save for the retirement lifestyle you’d like, check out our Retirement Guide.
If you’d like to hear more about pensions vs. mortgages, listen to this bonus episode of The Pension Confident Podcast. You can also read the transcript.
Risk warning
As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.
Last edited: 15-11-2024
