Should I buy a home with smaller deposit and keep some cash in savings?

Is it better to pay as large a deposit as possible upfront to reduce the size of the mortgage, or to use a smaller deposit? 

I know that larger the deposit, the lower the loan to value ratio, so you often get a better rate on the mortgage. 

However, with rates still being relatively high, even the slightly lower rate offered by a five-year fixed rate doesn’t seem all that appealing. 

The high interest rates on savings (5.2 pr cent) gets offset by the higher interest rate on the mortgage (5.4 per cent) without factoring the tax on the savings interest.

Mortgage help: Our new weekly Navigate the Mortgage Maze column stars broker David Hollingworth answering your questions.

Two scenarios I’m kicking around:

1) Buy a house valued at £120,000. Pay a £30,000 minimum deposit or £65,000 deposit

Or

2) Buy a house valued at £140,000. Pay £50,000 minimum deposit required, or increase it to £65,000?

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David Hollingworth replies: Managing a mortgage effectively should be about getting the best value throughout the life of the loan. 

If you can make the life of that mortgage as short as possible and keep the interest rate payable as low as you can without imposing any overly restrictive conditions, you will have done well.

The initial starting point will therefore usually be that having a smaller mortgage will help you get off on the right foot. 

There’s a number of reasons why that is likely to be the right approach for you but there are also some important caveats and alternatives.

Why does loan-to-value (LTV) matter?

At one time, mortgage lenders would tend to offer only a small choice of different deals with many offering a single rate all the way up to 95 per cent of the property value. 

Now, lenders have a multitude of different rate, fee and incentive combinations.

The current market splits the rates available into an array of LTV bandings and the very best mortgage rates are on offer to those with the biggest deposits. 

The keenest rates will typically be for those with at least 40 per cent of the purchase price to put down. 

Rates will then step up gradually as the deposit increases with those with the smallest deposits of 5 per cent facing higher interest rates.

As you’ve identified, reducing the deposit size could therefore have a detrimental impact on your mortgage rate, as well as meaning a bigger monthly mortgage commitment. 

However, the figures that you are proposing are at worst an LTV of 75 per cent. That could typically see a relatively small hit to mortgage rates compared to the lowest LTV bandings.

Why might you be thinking of taking a bigger mortgage?

The question of taking a bigger mortgage in a higher rate environment is no doubt provoked by the fact that savings rates can currently be higher than some mortgage rates. 

If you compare like-for-like two or five year fixed rates, the rates available on the best savings accounts are higher than those on the lowest mortgage deals. 

If you could earn more in interest on your savings than the mortgage would cost you it would seem to make your money work harder.

However, there could be tax to pay on savings interest income which will quickly erode the return. 

The personal savings allowance gives some buffer but the bigger sums you are considering would tip over those limits, especially if you have other savings.

That will quickly make the return look lower than the mortgage rate, especially when you take account of the fees that may come with the lowest mortgage rates. 

For example, the highest five-year fixed rate bonds are paying around 4.5 per cent, slightly higher than a five-year fixed rate mortgage of around 4.35 per cent to 75 per cent LTV. 

However, take account of basic rate tax and you’d need to earn 5.44 per cent gross just to equate to the rate you will pay on the mortgage.

Take account of fees

When you’re considering the relative mortgage rates to compare with savings don’t forget to factor in fees. 

The size of mortgage that you are considering will see the typical arrangement fees of £999 add a chunk of cost that may be best avoided. 

Better value may be found in a no fee deal but that will see the rate edge up a little further.

Access to savings

It’s always important to have easy access to cash savings. Buying a new property could bring unexpected expenses, so you need an emergency fund even more. 

It would not be sensible to put every last penny into the deposit and other purchasing costs.

One alternative that could help retain access to cash without incurring interest could be an offset mortgage. 

This means that you can draw on the cash if required but the savings balance reduces the interest payable on your mortgage, avoiding any tax as no interest is paid. 

The downside is that offset rates will be higher than a traditional mortgage, so you will need to weigh up how important that offset functionality would be.

In conclusion, although there will be reasons to retain some savings, the benefits of a smaller mortgage are likely to win out once all the above is taken into account.