Should you pay off your mortgage?

For example, in this week's reader portfolio, our reader is holding a large amount of cash together with a mortgage. If this applies to you then think carefully about what you are trying to achieve.

Over the years a handful of contacts have told me that you should pay off your mortgage before investing. The latest is Charles MacKinnon, chief investment officer at Thurleigh Investment Management: "The independent financial adviser (IFA) community hate me because I always say pay off your credit and debt. Then unequivocally pay off your mortgage because it's a guaranteed return. If I pay off my mortgage it is a guaranteed return forever.

"People's perception of money going out is not the same as money coming in. People have to think about reduced expenditure as increased income."

But what about people on low mortgage rates - with mortgage rates at the lowest they have been in decades does it even make sense to ever pay off your mortgage at all? A cash balance may yield more than you are paying on your mortgage, particularly for those who are lucky enough to be locked into mortgages linked to bank base rate.

Mr MacKinnon replies: "Say you can get 3.5 per cent on cash savings and are paying 0.5 per cent interest on your mortgage. You don't actually get that 3.5 per cent because you pay tax on your savings. A higher rate taxpayer is going to receive 2.1 per cent, so you're making only 1.6 per cent on the spread and you're locked in. If rates change and mortgage costs 2 per cent and your deposit pays you 2 per cent suddenly you are at risk of losing money."

Obviously this is a risk, but there other factors to consider.

Inflation will naturally erode your mortgage over time. Your mortgage is a fixed payment, therefore over time both the interest payments and the final capital repayment fall in value in real terms. Also, the lower the interest rate you are paying on your mortgage the less interest you will save by paying back some of your mortgage.

Average mortgage rates

Source: Moneyfacts.co.uk

Others would argue that if you have a low interest rate and a long timescale (for example, 25 years to pay off the mortgage) you could invest to pay off the mortgage. In the past, several products have specifically linked individual savings accounts (Isas) to mortgages, meaning equity investing was pitted against paying off your debt. However, Mr MacKinnon warns: "If you have your money in the equity markets you have to entertain the reasonable possibility of a 5 per cent loss in a year."

A mortgage also has to be viewed in terms of your own personal circumstances. In the extreme, owning your house outright is insurance against losing your job. Mr MacKinnon adds: "According to Options Theory, there is a value to having flexibility. If you have no mortgage you can always take one out. 'Can I keep up payments if I lose my job?' has real value. The cash value of not worrying should not be underestimated." I would also add that the feel-good effect of paying off your mortgage should not be underestimated.

Nevertheless, there is one definite area in which it makes better financial sense to contribute rather than pay into a mortgage and that is paying into a pension. It makes little sense to avoid contributing to a pension until you have paid off the mortgage as you would miss out on the income tax relief from pensions that will compound over the years. If you are a member of a workplace pension scheme you would also miss out on your employer's contributions and life insurance that is often built into the scheme.