Congratulations!!! You have saved quite a bit of money. Is it time to overpay your mortgage or should you invest? Here are 8 factors to consider:
1. Reflect On Your Big Dream?
Money is only a tool and just as you would want to decide what colour to paint a room and the effect you’d like to create before buying the paint and brush, so too should you reflect on the bigger 5-10 year dream before making the decision to overpay your mortgage or invest. This reflection exercise is even more important if you co-own your house with say a spouse or friend or relative.
Is your dream to be mortgage free as soon as possible? Perhaps you already know that in 5-10 years you are likely to move to another city or country and therefore paying down the mortgage is not that helpful to your plans. Maybe your dream is to open up a restaurant or another type of business? Or you’ve always dreamed of travelling the world and need a pot of money saved to make that happen.
Overpaying your mortgage generally means you have less ‘liquid’ cash available and limits your flexibility. However, investing gives you the flexibility to use the money to either overpay at a later date (e.g when it is time to re-mortgage) or for other things that bring you closer to YOUR dream.
Something I rarely see being mentioned when discussing this topic is if the home in question is a FOREVER HOME. A Forever Home is a house you intend to stay in for the foreseeable future. If you have kids or are planning on having kids, this would be the house that ticks all the boxes in terms of commutability to work/social network, good local schools, safe area for the kids e.tc. There might be stronger emotional and financial reasons for wanting to pay off the mortgage on your Forever Home than a house that you know you’d likely outgrow soon.
For example, say you are saving for a deposit for a bigger house over say a 5-year time horizon. Rather than overpay on the current mortgage and ‘earn’ a GUARANTEED 2% (I’ll explain this later) on your money, you might be better off investing that money in your diversified (NOT ALL In Individual Stocks) stocks and shares ISA and earn 5%..ish per annum – albeit NOT GUARANTEED. Earning 3% more per year by investing your money may get you to the target deposit for your new house faster.
2. Check That You Have Enough in Your Rainy-Day Fund
Financial planners often stress the importance of having an emergency fund that’s readily ACCESSIBLE AS CASH and typically suggest having 3-6 months’ worth of expenses in this emergency fund. Before considering over-paying on your mortgage, it makes sense to have cleared all high-interest credit cards and loans and to have 3-6 months’ worth of expenses saved for emergencies. On the subject of emergencies, I think now’s the time to mention something which you should DEFINITELY do, regardless of whether you decide to overpay your mortgage or invest.
You absolutely should get life insurance that at the very least pays off your mortgage if something was to happen to you.
3. Review Your Mortgage
It is time to fish out your annual mortgage statement and your mortgage offer (if you still have it somewhere). You can also phone your mortgage lender if you need to clarify anything. You need to know the following:
What is the interest rate on your mortgage? The interest rate loosely translates to how much your money will ‘earn’ if you over-pay your mortgage.
If it is a fixed-rate mortgage, how long before the fixed-rate period ends?
How much can you overpay a year before triggering the early repayment charge? (nb –lenders usually allow you to over-pay up to 10% of the outstanding debt without triggering the early repayment charge but do check)
How close are you to the next Landmark Loan To Value (LTV) threshold? See explanation below.
Is the interest on your mortgage calculated daily or annually? More often than not it is daily but do check. Interest calculated daily means that as soon as you over-pay, the interest paid adjusts to factor the amount over-paid.
Understanding Landmark Loan To Value (LTV) Thresholds
LTV is literally the total loan (mortgage) amount divided by the value of the property – turned into a percentage. If you borrowed £150,000 from the bank and your house is worth £200,000, your LTV is £150,000 / £200,000 x 100 = 75% LTV. Mortgage lenders’ interest rates typically get cheaper the lower the LTV. For example, the same mortgage lender might charge an interest rate of 1.99% at 75% LTV and 1.59% at 70% LTV. The difference between 1.99% and 1.59% can be quite significant in terms of monthly mortgage payments. The landmark LTV thresholds are often 60%, 70%, 75%, 80% and 85%.
If you are close to a Landmark LTV threshold, it means you save TWICE. You save on the interest you would have paid on the overpaid amount and you save by re-mortgaging to a cheaper interest rate. In the example above, say you saved £10,000 and you overpaid the mortgage. You would no longer pay 1.99% interest on that £10,000. As the loan has now reduced from £150,000 to £140,000, the new LTV would be £140,000/£200,000 x 100 = 70%. Let’s assume you are able to re-mortgage as you are at the end of your fixed-rate term. This means that the £10,000 would have also pushed you into a cheaper interest rate of 1.59% for the rest of the loan. That’s brilliant isn’t it?
One important point to remember if you decide to over-pay your mortgage. The lender may offer you the option of a REDUCED MORTGAGE TERM (e.g 25 years to 20 years) or to REDUCE THE NEXT MONTH’S PAYMENT by the amount overpaid. For most people, it makes sense to choose to reduce the next month’s payment. This is because a reduced mortgage term often means that you loose the flexibility to reduce your monthly mortgage payments if money is a bit tight at some point in the future.
4. Work Out the Return On Investment (ROI)
In simple terms, Return On Investment is a way of assessing the pay back of an investment decision relative to the amount invested. Have a look at this article I wrote for a detailed explanation, with examples.
Let’s start with the ROI of overpaying your mortgage. Say the current interest rate on your mortgage is £1.99%. This means that the mortgage lender (bank) is charging you 1.99% interest on the amount they’ve lent you. As most residential mortgages tend to be on repayment terms (i.e you’re paying the INTEREST on the loan and the CAPITAL component), you would need to examine your mortgage statements to work out how much of your monthly mortgage payments is going towards paying just the INTEREST component.
Say you had £10,000 saved. Overpaying £10,000 means that the mortgage lender will no longer charge you 1.99% on that £10,000, which means you’ve ‘earned’ 1.99% and we can call this your ROI. Note that this 1.99% can be regarded as ROI AFTER TAX and that this ROI is a GUARANTEED ROI.
What else could you do with the £10,000? You could invest it in a Stocks and Shares ISA with investments in a well-diversified low-cost tracker fund. Let’s take a low-cost fund tracking one of the main indices for example. The FTSE 100 index generated an annualised return of roughly 6% for the 5-year period ending January 2020. The FTSE 250 and S&P 500 generated annualised returns of roughly 8% and 12% respectively in the same period.
Because it is a Stocks and Shares ISA, there will be no tax to pay and therefore the 6% FTSE 100 annualised return gives a ROI that is 4% more than you would get if your £10,000 is used to overpay the mortgage in this example. 4% of £10,000 is £400 and so not exactly earth shattering in absolute terms. However, remember that this is £400 per year and if profits are re-invested, compounding would increase the ROI over the 5 years. This is a simplistic example as the markets will go up and down and therefore the 5-year average of 6% includes some years when the ROI is greater than 6% and some years when it is lower than 6%. The problem is that these returns are NOT GUARANTEED and you need to be willing to invest for the LONG TERM to ride out the ups and downs of the market.
Imagine if you decided to follow Warren Buffet’s mantra of being greedy when others are fearful and invested the £10,000 in a FTSE 100 tracker during the first 6 months of the Covid pandemic and then saw your £10,000 grow by 30% to £13,000? How about if you invested in one of the US Electric Vehicle stocks back in early 2020 and saw your £10,000 go DOWN to £7,000? Would you have been able to handle the paper loss? Would you have turned that paper loss into a real loss by selling because you were concerned that you might loose more? Perhaps you would have dug your head in the sand and ignored what was happening, and then your misery may have turned to shock happiness as you watched it rise to £25,000 over a 9-month period, thus making a 150% return on your £10,000. You’d be so happy that you made the decision not to overpay your mortgage.
You could put that £10,000 into your PENSION? Thanks to the government’s pension tax relief, that £10,000 automatically becomes £12,500 as a basic rate tax-payer or £15,000 as a 40% higher rate taxpayer (nb: this is a general guide – do check the latest pension rules). Using the previous example of investing in a low-cost FTSE 100 tracker fund, you could now be getting 6% on the £12,500 (basic rate tax-payer) or £15,000 (higher rate tax-payer). Of course, the downside is that you can’t touch your pension till the minimum pension age (currently 55)
You could also invest that £10,000 in investment property. Here is an article I wrote about 15 property investment strategies made simple. There are also other asset classes such as gold, commodities and cryptocurrency. The point is that you need to work out your likely ROI over the investment time horizon and decide if this beats the interest rate on your mortgage.
5. What Is Your Investment Experience?
For many people, investing sounds scary. If you choose not to over-pay your mortgage, how likely are you to actually invest the money? Are you more likely to stick it in a high interest savings account that isn’t paying as much as the mortgage interest rate? Do you know how to invest? Are you willing to learn? What is your risk appetite? Will you get very anxious if there is a dip in the market? If you know, deep down that you don’t have the time or inclination to invest, then it’s probably best to over-pay your mortgage.
6. Does it Make Sense to Do Both?
We often talk about over-paying the mortgage or investing as if we have to do one or the other, but the reality is that we could do both. Using the earlier example of saving £10,000. This could be split into two pots: perhaps £5,000 to overpay the mortgage and £5,000 to be invested in a pension. The money split very much comes down to your plans and dreams (see consideration 1 above)
7. Reflect On Your Psychological Profile
Some people are comfortable with debt, while others feel burdened by it. If you fall into the latter, it might make sense to over-pay your mortgage as there could be feelings of happiness and positive mental wellbeing associated with paying off some of the mortgage debt. Are you a spender by nature? Will you find it difficult to resist the temptation to cash out your investments and spend? If that’s you, then over-paying the mortgage might be better so you don’t spend the money.
8. Is Being Mortgage Free As Soon As Possible a Life Goal for You?
In the Financial Independence community, there are examples of people who’ve managed to pay off their mortgage in their 30’s and 40s and they’ve tended to achieve this by saving aggressively and overpaying their mortgage. As mortgage costs are typically the biggest drain on salaries, being mortgage free can feel LIBERATING. You may feel less shackled to a job and FREE to explore other opportunities, with less fear of the financial consequences of failure. The resulting cocktail of FREEDOM, CHOICE and potentially more TIME could be the catalyst for people to go on to achieve amazing things.
On the flip side, overpaying to the point of being mortgage free, represents a concentration of wealth into one asset and less liquidity. Furthermore, you’ll loose out on the advantage of LEVERAGE if house prices rise. If you’ve paid off a mortgage on a £300k house and it rises to £400k, your £300k would have earned £100k (33% return). However, if you paid a deposit of £100k and took out a mortgage of £200k on that same £300k house and it rose to £400k; your £100k would have earned £100k (100% return). Yes, the person who had the mortgage for £200k would have been paying interest, but as interest rates are so low, this would NOT come close to equalising the return in both scenarios.
I prefer to think in terms of being TECHNICALLY MORTGAGE FREE, which means being mortgage free across:
A CAREFULLY constructed portfolio,
Delivering MAXIMUM ROI,
That fits one’s RISK APPETITE
And that has been set up properly from a TAX perspective.
This would mean, rather than paying off the mortgage on a £300k house and saving say 2% interest, perhaps refinance to 50% LTV (this means taking out a mortgage for £150k). For starters, 50% LTV would attract the best mortgage interest rates and one could even get an interest only mortgage, which means very little monthly mortgage costs (so one still gets the benefit of freedom and choice as described above). Then that £150k could be invested in whatever asset classes float your boat, so long as you understand the RISKS and can generate an ROI (net of TAX) that is significantly above the interest rate you would have saved by being mortgage free.
I’ll round up this article by outlining the main Pros and Cons in a table
Over to you to make a decision