How can I spend settlement?

Anne Shirley, 48, a recently divorced teacher from Birmingham, writes:

'I have just bought a house with a repayment mortgage of £80,000. The loan from Northern Rock is on a fixed rate for two years and costs me about £400 a month. Apart from that I have no debts.

'I have spent some of the money I got after my divorce, partly in lieu of my share in my ex-husband's pension, on my new home - about £8,000 on a new kitchen and other items. But I have a considerable amount remaining and I am not sure how I should invest it.

'Before the end of the last tax year, on the advice of my brother, I put £7,000 into an Isa invested in the Standard Life UK Smaller Companies fund. The remaining £95,000 is currently in a Barclays bank tracker account but I feel it can be invested better.

'I would like to invest £10,000 on behalf of my son who is in his first year at university so that at the end of his four-year course he will have enough to pay off his student loan. I don't want to take any risks with that money.

'One of the reasons I decided to get a mortgage instead of paying for my new home outright is because I thought I could make better use of my money by investing it. Also, I knew I could afford a mortgage as interest rates are low and I thought it would be useful to get a 'track record' as a borrower in my own right in case I wanted to borrow any more. But there is no early redemption penalty on my mortgage so I can pay it off early if I need to.

'I am not sure whether I should consider early retirement. I have been a member of the teacher's pension scheme for more than 20 years and have been paying AVCs of £30-£40 a month into the Prudential's with-profit scheme since the mid-1980s.

'Another thing worrying me is that I don't have any life or critical illness insurance. I would like to take out these policies but I wonder if it would be prohibitively expensive at my age.'

Action plan

Let's deal with your son first. Financial adviser Ian
Millward of RJ Temple points out that if you are
committed to clearing his student loans in four years'
time you cannot afford to take any risks, so the only
thing you should consider is cash. 'A starting point
should probably be for Anne to use her son's ?3,000
mini cash Isa allowance to get the best tax-free rates.'

However, he points out that student loans are relatively
cheap money and that your son is bound to have other
big commitments shortly after finishing his studies, so
your money may be better used for, say, a deposit on
a house.

If you decide to think longer term you could consider
alternative investments with the prospects of better
returns. Millward suggests a protected stock-market
bond, such as one offered by Key Data, which runs for
five years and pays returns linked to the stock market
but with some capital protection if the market falls in
value.

Turning to your own finances, you really must decide
whether you want to retire early as this will determine
your investment strategy. With 20 years' pensionable
service and long-standing AVCs you can expect a
reasonable pension but it will be reduced if you retire
early. Contact your pension scheme and find out how
much you will get. You will then be able to ascertain
whether or not you can afford to retire early.

As you have chosen to invest rather than clear or
reduce your mortgage, you need to aim to beat your
mortgage rate of about 4 per cent to make it
worthwhile, which means you cannot just look at cash
accounts. This means you will have to be prepared to
take some risk.

You have already shown you are willing to take risks
by investing in Standard life UK Smaller Companies.
Millward agrees this is a good fund, but points out that
you need an overall plan rather than a collection of
individually good funds. He says you should aim for a
spread of investments across cash, bonds and shares.

A healthy rainy day fund is the starting point of any
portfolio. A sum equivalent to about three months'
outgoings is the usual rule of thumb. Millward suggests
a minimum of ?10,000 in a good savings account. You
can then consider other types of investments. He
suggests you put this year's ?7,000 Isa allowance into
New Star High Yield Bond fund, plus a further ?7,000
into Threadneedle Strategic Bond fund, both of which
invest across a mix of higher and lower quality bonds
so you have some spread of risk. These funds can be
used to generate income in the future.

He then advises you to spread a further ?30,000
across investments such as the Key Data bond
already mentioned and low- to medium-risk funds
containing bonds and shares, such as Gartmore
Cautious Managed and Jupiter Distribution fund. You
could invest the remainder across a number of
share-based funds such as: Cazenove Growth &
Income and Liontrust First Income for UK exposure;
and for overseas exposure Investec European, DWS
American Growth, First Start Asia Pacific and
Framlington Health.

If you follow this approach you will have to be prepared
to lose money if bonds and shares go down in value.
An alternative strategy suggested by Neil Moss of
financial advisers Maskell Moss would be to consider
switching to an offset type mortgage, offered by
lenders such as Intelligent Finance and the Woolwich.

He says: 'If you have capital on deposit matching your
mortgage, there will be no interest to pay on your
mortgage. However the monthly repayment remains
the same and will therefore help to repay the mortgage
early. This is a halfway house to repayment, as you
are utilising your capital to offset your loan but you can
still access it if you need it.'

Moss agrees you should take out life cover for your
mortgage. Term assurance is the cheapest option and
he points out that you can keep the cost of your
critical illness insurance down by combining it with
your life cover so the sum assured is paid out on the
first event - either critical illness or death.

Anne's plan

1. Use your son's mini cash Isa allowance to put
money aside tax efficiently to pay his student
loans.

2. Decide if you are serious about early
retirement. Ask your pension scheme how much
you will get if you retire early.

3. Aim to clear your mortgage by the time you
retire. You may want to consider an offset
mortgage if you still want to retain access to your
capital.

4. If you are happy to take more risk, you need to
build up a spread of investments. Start with a
minimum of ?10,000 in a rainy-day cash deposit
and divide the remainder between bond and
share-based funds.

5. Take out term assurance combined with critical
illness insurance to cover your mortgage.

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