Forget deposits: knock €10,000 off your mortgage and reap much greater rewards

While Irish savers are not quite stuck with the conundrum that are negative interest rates, returns are nonetheless plummeting.

Indeed if you are earning more than 1 per cent on your deposits in the current environment, you are probably doing well.

So what should you do?

Well, the easy option for those looking for a better return is to take on more risk. However, given the volatility of markets, this may not be the answer for everyone.

So this week we look at three ways you can maximise the return on savings you may have by putting them to use elsewhere; next week we'll take a look at some ways you can increase your yield.

Before you consider diverting any savings from deposits, it is worth noting the potential consequences of such a move.

As financial adviser Vincent Digby of Impartial Financial Advice warns, using your savings to pay down debt or put into a pension, as this article suggests, does equate to a loss of liquidity. This means you you will not be able to access your funds if you need to do so at some point in the future.

“Surprises and unanticipated costs are a fact of life,” Digby says. “We all have unforeseen financial burdens we have to deal with.”

So, before you give up on low deposit rates, consider your options carefully and ensure that you have an emergency fund worth at least six months in expenses to hand – on deposit – should you need it.

Mortgage debt

If you turned green with envy at the story of Canadian man

[ Sean Cooper ]

who paid off his $255,000 mortgage in just three years, you may be interested in trying to make some inroads into your own mortgage debt.

And with returns on your savings so low, could your money work harder for you by reducing your mortgage?

For Digby, it comes down to the interest rate you are paying.

“If you’re on a high rate SVR it’s definitely an option worth looking at,” he says.

Typically, if your mortgage rate is higher than the post-Dirt rate you would earn on your savings, then it makes financial sense to overpay your mortgage

Indeed, if you are paying more than 3 per cent on your home borrowings, it would likely make sense to divert some of your low-yielding savings into your mortgage account. And as deposit rates continue to plummet, it may even make sense for someone on a low-cost tracker to do likewise.

Overpaying your mortgage works on the same principle as shortening the term of your mortgage – ie reducing the term from 25 years to say 20 years – but it comes with the flexibility that you can stop overpaying at any time, should your finances require it.

Consider someone on a €250,000 mortgage with 17 years left to go in the term paying interest at a rate of 3.7 per cent. They are currently making repayments of €1,653 a month, but if they could increase their repayments by €100 every month, they would knock 16 months off the term of their mortgage and save themselves €7,302 in interest (based on interest rates staying where they are). If they could bump up this payment to €200 a month, they would cut the term by 30 months and save themselves €13,454 in interest.

Or let’s say they have €10,000 on deposit earning 1 per cent. After a year they would have €10,100, or €16,642 after 17 years (based on an average interest rate of 3 per cent). If, instead, they put this against their mortgage, they would reduce their term by 39 months and save €20,364 in interest over the life of the mortgage. That is 39 months with no mortgage payment, plus €20,000 in interest saved, versus about €6,500 in interest earned – which, of course, is subject to Dirt at 41 per cent (or 45 per cent).

And just because you are on a fixed rate does not mean that you are precluded from paying extra off your mortgage. Bank of Ireland, for example, allows you to overpay your fixed rate mortgage provided you don’t go over certain limits. The limit is the greater of 10 per cent of your monthly mortgage repayment or €65. So, for example, if you repay €1,200 a month, you will be able to repay €120 a month. Similarly, KBC allows its fixed-rate customers to overpay up to 10 per cent of the repayment without incurring a penalty.

Another advantage of overpaying is that doing so shrinks your loan to value (LTV) ratio – ie the size of the loan in relation to the value of the property – at a faster rate. And the lower your LTV, the lower the interest rate the bank will likely offer you and the easier it will likely be for you to switch mortgage providers, if you so wish.

Remember that if you want to overpay, be sure to tell your mortgage provider that you want the additional funds to go against the principal outstanding; don’t rely on them simply doing so.

“I would be explicit with your bank,” says Digby.

And bear in mind earlier advice that once you put this money against your mortgage, it is unlikely you will be able to get it back again should you need to do so.

“It’s the only real negative of paying it off,” Digby says. “It may also be harder [to borrow] if you need additional borrowings in the future.”

If you were given an option of either getting a 1 per cent return on your money or getting as much as 66 per cent, which would you choose? Surprisingly, it seems most of us would choose the former, given that so many of us still fail to think clearly about saving for our retirement.

However, as John McInerney, senior technical consultant with Standard Life says, opting for a pension over deposits can be the smart option.

Thanks to tax relief of as much as 40 per cent for higher rate taxpayers, a €10,000 investment in a pension might cost you as little as €6,000; hence the “return” of 66 per cent. In addition, the investment may also grow considerably beyond your initial allocation over time.

As McInerney notes, if you are very risk-averse, there is no reason why you can’t opt for deposits for your pension, with the added bonus of tax relief.

“You can take your tax relief and invest it in a deposit account,” he says.

Close to retirement

Opting for a pension over deposits may make even more sense if you’re closer to retirement.

McInerney gives the example of a 59-year-old with a €50,000 defined contribution scheme and a €50,000 salary, who is one year away from retirement.

“Under Revenue rules, you can get 1½ times your salary tax-free, so €75,000 as a lump sum from their scheme when they retire,” he says.

But at present, at just €50,000 the pension is not large enough to qualify for this tax relief. So, rather than put €25,000 on deposit, if this person had the funds, by injecting it into their pension they would get tax relief on it so it wouldn’t cost them the full €25,000 and would be able to draw down the full €75,000 tax-free in a year.

“The Holy Grail of pensions is to get tax relief on the way in, and then you don’t pay any tax when you withdraw from the pension,” McInerney says.

At the other end of your pension, when you go to draw it down, interest rates are also having an impact. Irish-based insurance companies invest mainly in European government bonds and the yields on these bonds are at historic lows, which in turn, is having a downward impact on annuity rates.

Back in 2007, for example, you might have reasonably expected to get an annuity rate of about 6.6 per cent for a 65-year-old or 5.71 per cent for a 60-year-old, according to McInerney.

Fast-forward almost 10 years, however, and these rates have shrunk to 4.3 per cent for a 65-year-old and 3.7 per cent for their younger counterpart. This means that a 60-year-old with a €100,000 pension pot would only get an annual income of about €3,700, down from €5,710 some nine years ago.

“They are very poor compared to what they were,” says McInerney, noting that this is pushing more and more people into approved retirement funds (ARFs) which allow them to keep their capital invested, rather than convert it into an annuity.

Saving at 1 per cent and keeping a debt outstanding at 10 per cent rarely makes sense. Yes, if you have little savings to hand then you may need to prioritise this to build up a rainy day fund. After this, however, it is usually best to use any extra cash you have to pay down credit card bills and car loans.

Let’s say you have credit card debt of €10,000, racked up at an interest rate of 18.5 per cent. If you make just the minimum payment, of about €250 each month, it will take you more than five years to repay your debt. Not only that, but you will rack up a staggering interest bill of some €5,669 in that timeframe. It is much better then, if you have any spare cash available, to try to pay down this debt.

Reducing debt

If you could bump up those repayments by an extra €100 a month, your interest charge will drop to €3,824 and you will have no payments for two years less, as you will repay your debt within 38 months.

Increase it again to €400 a month and your debt bill will drop to €2,728 and you will repay the debt and interest in just 32 months.

If instead you had locked this €150 a month into a regular savings account, you may well have earned less than €150 in interest over the course of three years. It is worthwhile, then, to reduce your debt with the same money.

At the same time as overpaying your monthly repayments, you should consider switching to a lower rate card. If you switch to AIB’s Platinum Visa card, for example, you could repay your debt in 51 months, as opposed to the 63 mentioned above, thanks to its introductory offer of 3.83 per cent for the first 12 months.

Another option is KBC’s 0 per cent for the first six months special offer. However, due to the lower term of the offer, it will actually take you longer – 55 months – to repay than AIB’s offer.