As a financial planner, it’s no surprise that I’m often asked where people should put their money. Clients want to know if it’s best to save into an ISA, contribute to their pension or repay their mortgage. The simple answer? All three!
The benefits of investing in an ISA
Individual savings accounts (ISAs) are straightforward in theory. Money is invested and can then be withdrawn with no tax implications. In my opinion, cash ISAs are a waste of time. The ‘tax-free interest’ they offer is no higher than the individual allowances of £500 or £1,000 that most people already hold and so there’s no real incentive to ditch a standard savings account with a decent interest rate for a cash ISA.
Stocks and shares ISA carry an inherent risk as no investment can ever be guaranteed and the value can go up or down. However, providing you’re only investing money that you can afford to lock away for a reasonable period of 5 years or more your returns should be greater than both cash ISAs and the rate of inflation.
If you’re under 40 and saving for a home, a Lifetime ISA is a specific account that could prove particularly beneficial. (You must make your first payment before turning 40 but can then continue to invest up to £4,000 per year until you turn 50.)
Securing your future with a pension
Retirement can seem a long way off and sometimes, unfortunately, pensions end up getting overlooked. Thankfully, the introduction of compulsory workplace pensions means the majority of employees now contribute into a pension, often with additional contributions from their employers and with guaranteed tax relief from the government. (This ranges from 20% to 60% depending on your earnings and tax band.)
Pension contributions also have an impact on net income figures for tax and benefits thresholds. This can prove particularly useful if, for instance, you earn just over £50,000 and claim child benefit. Calculating pension payments to bring yourself beneath the £50,000 threshold allows you to retain all of your child benefit and avoid having to complete a self-assessment tax return.
The key potential downside of putting money into a pension means it is completely locked away. But assuming you don’t want to work forever, you’ll need to secure some money for the future. And, not a subject we like to dwell on, but if you were to die before you turned 75, a pension is absolutely the most tax efficient asset to pass on to your loved ones; unless you have more than £1 million in your pension (which is unlikely!) there will be zero tax for your family to pay on those funds.
Reducing your interest with mortgage overpayments
Most mortgages on primary homes are capital and interest repayment (rather than interest only) so you are already repaying your debt with your monthly payments. Each month, you’ll be chipping away at the original loan as well as the accruing interest.
Most providers allow a certain level of overpayment each year with no penalties. A modest overpayment of £200 per year (that’s less than £17 per month) can make a huge difference across the duration of your mortgage. For instance, if you have a loan of £130,000 set at a 25-year term and 3.5% interest on the repayments, paying an additional £200 per year will save you almost £23,000 of interest and allow you to pay off your mortgage more than 8 years earlier than with the standard repayments.
You can’t really argue against those numbers and the added bonus of the joy of owning your home outright!
Wherever you’re saving your money, you’re taking positive steps – there’s no one right way to invest in your future. But if you can maximise the benefits of your pension, take advantage of healthy returns from mid-term stocks and shares ISAs and supercharge your mortgage repayment by making the most of the overpayment allowances, you should find yourself in a strong position.
To cover all bases, I should mention that before topping up your savings in any of these ways, it’s worth considering repaying any short-term loans, overdrafts or unpaid credit cards first. The charges levied on these loans can be eye-wateringly high and avoiding short-term borrowing is a good habit to get into. We also recommend building up a cash reserve so that you can cope if an unexpected bill comes in or there’s a sudden change to your circumstances.