In this article from The IRS Report in December 2008, Chris Gilchrist discusses the benefits of not overpaying your mortgage.……

Why it pays not to overpay

You could use the latest cut in mortgage rates to "overpay" your mortgage. Instead of lowering your repayments, you keep them the same. The result is you'll pay your loan off early and save a packet in interest. Many people feel that getting rid of their mortgage a few years early is a good thing and journalists go along with this with articles showing how many years earlier you will be "free of debt" if you overpay.

But go through the figures carefully and you'll see that overpaying doesn't necessarily make sense. In fact, if you have over 15 years left on your loan, it's probably more advantageous to use the money another way.

I will assume you have a £100,000 loan outstanding with a term of 25 years. Of course most people don't, but you can work your own figures out using a flexible mortgage calculator such as mortgage brokers Charcol's (www.charcol.co.uk).

I'll assume that you have a tracker mortgage on the terms of "base rate plus 1%". That means you were paying 5.5% and after the latest big cut are now paying 4%. Your monthly repayments were £614 per month and are now £528 per month.

What happens if you use some of that £86 pe month saving to overpay your mortgage? I'll assume you use £75 per month and therefore pay £603 per month instead of £528 to the lender. The result is that you will pay your loan off after 20.2 years instead of 25, and that the total cost of repayment will fall by £12,500 from £158,300 to £145,800.

An obvious question is why you have to make total extra payments of £18,180 (20.2 years at £75 per month) to save £12,500 in interest. It is because you have accelerated the repayments, so that each of your new monthly payments contained more capital.

Paying the loan off almost 5 years will strike most people as a big advantage. Unfortunately this is based on the feeling that it is good to be "free of debt" without giving any thought to the actual return on your money. If someone tried to sell you a retirement savings plan and said: "It's a pretty good plan - you get 4% interest", how would you respond? I am pretty sure you would say "Rubbish!" because over a 25-year term a 4% return is rubbish. Historically, the average you have got over that period in the stock market is about 5% on top of inflation, so if you were to assume an average inflation rate of 2% you could expect to get a 7% return on your savings. investing in your mortgage to earn 4% doesn't seem so clever.

Instead of overpaying your mortgage by £75 per month, suppose you put the £75 into a regular stock market savings plan. After 20.2 years, assuming a 7% annual return, the plan would have a cash-in value of £40,000. Your outstanding loan at that point, assuming you'd kept your monthly repayments at £528 per month, would be £20,000. So you could pay off the rest of the loan and have £20,000 in the bank, and be £20,000 better off than if you'd overpaid your mortgage.

Back in the 1980s, people who had used "endowment mortgages" - which meant a with-profits endowment policy alongside an interest-only mortgage - ended up with surpluses of 20-30% at the end of their mortgage term. But the endowment mis-selling scandal put people off this idea. There is also a wrinkle, one that sunk millions of people with endowment mortgages.

The amount you need to put into a savings plan inorder to repay your mortgage on the due date,assuming you earn the same return as you are paying on your mortgage, is the difference between the repayment mortgage and the interest-only mortgage repayment figures. To take a simple example, the monthly repayments on a 25-year £100,000 loan at 4% interest are £528 and £333 respectively. The difference is £195 per month, which if saved at 4% compound will deliver a lump sum of £100,000 after 25 years.

The problem is that if you have variable interest mortgage and interest rates change, you need to alter the amount you save. People with endowment mortgages didn't do this, so many of them ended up saving too little and now have shortfalls.

So using a savings plan to accumulate capital to pay off a mortgage can and does work, but you have to adjust the figures when interest rates change. This means it is a lot easier to manage if you have a fixed-rate mortgage.

There are many reasons why people don't adopt a mortgage-plus-savings plan strategy. I can think of only two valid ones:

• The remaining term on your mortgage is less than ten years. Over this period, the return on a stock market savings plan could turn out less than the interest rate you pay on your mortgage. So there's a chance you'd be better off overpaying - though it's still more likely that you'd come out ahead with the savings plan.
• You plan to move home in the next ten years. In that case, this strategy exposes you to some risk, because if you want to trade up, you'll need to increase your mortgage or cash in your savings plan. If the stock market and the cash-in value of your savings plan are down, you may have less equity than if you had overpaid your mortgage.

In these situations, it could make sense to overpay. Otherwise, you will be better off using a saving plan, especially now.

This is only the second time in all my 35 years in the financial markets when the cash-in value of a simple 10-year stock market savings plan is less than what you'd have got in a deposit account. The recent performance of the stock market has been so dismal that there will almost certainly be big gains at some point in the next decade. If your timescale is 15 years or more, you can afford to wait for this.

I believe that stock market plans are only the fail-safe route to profits - see The IRS Report Issue 288 - and that a simple regular savings plan using a fund supermarket such as Hargreaves Lansdown Vantage or FundsNetwork will probably deliver 10-15% annual returns over the next 10-15 years - a figure they have often achieved in the past. Low mortgage interest rates give you a great opportunity. Collecting a 7-10% margin between the rate you pay and the rate you get is a slow and simple way of adding to your wealth.

You can see all of Chris Gilchrist’s articles at www.TheIRSReport.com.

Chris is the editor of The IRS Report every month.

Call 0800 756 5437 or click here for more information.