This was the question I was asked by a friend last week. So I put my Amateur Investor head on and proceeded to bestow my, sometimes informed and sometimes rank amateur, advice upon him…
But first things first, a quick background.
My friend is employed (basic rate taxpayer), single, has a mortgage (currently 3.29%), no dependants, no credit card bills, no loans (apart from the mortgage) and a bit of money tucked away in a cash ISA.
So what did I advise he did with the £1000? (please note, figures mentioned in this post will be rough estimates).
Well, if he had credit card debts I would have suggested he use the £1000 to reduce the credit card debt. If we say his credit card interest rate was 15.9% then there’s no way he could hope to earn 15.9% per annum on his £1000 in a savings account. So by using the £1000 to pay down his credit card he would effectively be saving 15.9% of £1000.
But he doesn’t have credit card debts.
He could put the money into the Coventry Building Society Poppy Saver account (3.15% per annum), but with inflation currently running at 4.2% (CPI) and 5.0% (RPI), in real terms his money would be falling in value.
“What about the stock market” he asked.
“Well, that’s an option“, I replied. Choose a good reliable (if there’s such a thing) dividend payer and you could see an income of over 7% (the likes of RSA are currently yielding over 7%. He would have to pay dealing costs of around £10 (lower if he chose a low cost online broker), and stamp duty of 0.5%.
A yield of 7% would generate £70 of income per annum. Enough for a nice meal for two, but not much more. And, of course, there’s a risk to your capital if you invest it in the stock market.
Although a yield of 7% is good in the current economic climate, I can remember the AA paying over 7% to their savings customers not all that long ago. And the capital would have been “safe” (the Financial Services Compensation Scheme is “the compensation fund of last resort for customers of authorised financial services firms” and will pay up to £85,000 per person per firm should a firm covered by the scheme default).
“What about your mortgage“, I said. “Oh that’s only 3.29%” he said. “That’s one of the cheapest debts I will ever have“.
True, I cannot think of another type of debt that is cheaper that 3.29%, but then there aren’t many other debts that can last 25 years, or longer.
A very rough calculation tells me that if he paid this £1000 off his mortgage he would save around £5 per month (reduced monthly capital repayment and reduced interest costs). Not much, no. But then it’s “the gift that keeps on giving” – He will save money month after month. It’s like earning interest on his £1000, and using the interest to reduce the mortgage each and every month.
Some mortgage providers will recalculate your monthly payment when you make an extra capital payment, reducing your monthly repayment. Or you can leave the monthly payment the same and, effectively, be “overpaying” each month.
And remember, interest rates are at historic lows and will, sooner or later, start to rise. At which point the £1000 he pays off his mortgage will be saving even more money per month.
“So what would you do with the grand” he said.
“I’d pay down my mortgage and be happy that the noose around my neck in £1000 lighter. And get a warm feeling every month when my mortgage statement drops through the letterbox showing a smaller interest figure“.
So what about you (assuming you haven’t fallen asleep by now). What would you do with a £1000 windfall?