An interesting topic that is hotly debated in the personal finance circle. With interest rates at their lowest point for decades, this often turns into a duel between emotions and maths.
Let battle commence!
First up, US advice isn’t going to fly here.
Mortgages are yet another area that the US does differently to the UK. If you’re coming here with US centric advice burning your ears, you’re probably going to end up confusing yourself. Let’s clear up the differences.
- US mortgages are typically fixed for a lot longer than UK mortgages. Fixed term and variable mortgages exist in both ecosystems, but a fix for the life of the loan is not uncommon in the US. In the UK the longest fix traditionally on offer is about 10 years long (and you’ll usually pay heavily for this). This makes a big difference to the numbers.
- The terminology is a tad different. In the UK we call finding a new interest rate, provider or borrowing more “remortgaging”. In the US a “remortgage” doesn’t really exist, they refer to this as “refinancing”.
- Because US mortgages tend to have such longer fixed terms, they typically have to pay a lot more to swap products or lenders – often referred to as “closing costs”. In the UK we are free to swap about without fees once our fixes expire (unless you choose a product that has a fee of course!).
- LTV (loan to value) matters for both countries, but matters more for us in the UK because, you guessed it, we remortgage a lot more. Calculating your LTV bracket and planning around this can play heavily into your numbers.
- PMI (private mortgage insurance) does not exist in the UK but is compulsory for US mortgages that have an LTV above 80%. Yep you heard that right, in the US you need to pay for a special form of insurance if you have anything less than a 20% deposit. Once again, this will impact the numbers.
With that out of the way and hopefully cleared up, we can move onto examining the question at hand:
When does it make sense to overpay a mortgage?
To best address this we need to understand what actually happens if you overpay a mortgage. For those of you that are lucky enough to be home owners, you may notice that the terms of your mortgage allow you to “overpay”. This is usually capped to a certain % of the balance for fixes and unlimited for tracker products. For almost every mortgage taken out in recent memory, an overpayment does one of three things:
- It immediately reduces the outstanding principal on your mortgage, thus reducing the interest accrued on the life of the loan, regardless of your mortgage type.
- It will then either:
- Reduce your monthly payments by a set amount based on your overpayment.
- Reduce your mortgage term (the amount of time left until the mortgage is paid off).
- Some combination of the two above, usually defaulting to option 1 then option 2 when the fix ends.
From this information we can conclude that overpaying your mortgage earns you a total return exactly equivalent to your mortgage interest rate. This means that if you overpay your mortgage and your mortgage interest rate is 2.5%, this has exactly the same yield, in terms of return, as saving cash into a 2.5% interest rate account.
Simple? Sort of.
What return do I get by overpaying my mortgage?
Think of it this way:
Suppose you have a £150,000 mortgage, on a 25 year term, currently fixed for 5 years at a 2.5%. You’re contractually obligated to pay £673 every month for the first 5 years. If you’ve got a spare £200 each month you could pump this directly into your mortgage, effectively choosing to pay £873 a month. Where would this get you after 5 years?
Without the overpayment your 5 year fix would end with a balance owing of: £126,993
With the overpayment your 5 year fix would end with a balance owing of: £114,225
Looks good right? To be mortgage free all the sooner! But look a little closer under the hood. The difference between the two values (£12,768) shows you just how hard your money worked for you in this 5 year period. You put in £200 a month of your own cash for 5 years or £12,000. That means, in this scenario, your contributions returned you £768 which is exactly the same as letting your money grow at 2.5% interest in a savings account. Try it out on a compound interest calculator if you don’t believe me. The numbers will be very close.
As of writing this article no savings accounts offer 2.5%, so in that regard overpaying your mortgage mathematically offers a better return than cash in the bank.
But there are significant drawbacks to consider.
Mortgages are very, very illiquid. Your home is not a savings account.
Overpaying into modern mortgages is a little different than it used to be. Certain lenders such as Nationwide used to set up an “overpayment reserve” that meant if you overpaid previously, you could use this to fund future mortgage payments if times were tough. This is no longer the case as lenders have become a lot more strict. This means that overpaying a mortgage is highly illiquid. The only way to “get money back out of” a house (or an overpaid mortgage) is to either sell the property or remortgage and request a bigger loan. Which comes with a new interest rate and potentially a new fee. Getting, say, £300 back out of your previous mortgage overpayments is borderline impossible.
The question remains, can we make our money work harder for us?
Enter the alternative, investing into stocks, shares, bonds, cash or ideally a mixture of all of these. By selecting products that will return a greater rate than the mortgage rate, you’ll be quids in! But of course it is never quite so simple.
A mortgage is a guaranteed rate of return. This means it is a risk free way of getting your money working for you. Insured cash deposits (e.g. current and savings accounts) are also guaranteed. As it stands, no savings accounts consistently beat mortgage rates, so this idea is out for now.
A diversified portfolio of bonds and stocks has a variable rate of return. Now we can see the risk factor come into play. By investing into the markets we will likely beat lower mortgage rates over the long term but we may lose out against them in the short term.
How much more could I earn by investing instead of overpaying?
The long returning average for a balanced portfolio of global bonds and equities is in the region of 6-9%. This is significantly greater than the return on the mortgage example above. If the individual above instead invested the monthly £200 for 5 years and achieved a return of 6% they would expect to have a final investment balance in the region of £14,023. This is a return of £2,023 – remember the mortgage? That returned only £768 in comparison. In this scenario, by choosing to invest, this individual would have earned an additional £1,255 for doing absolutely nothing. Seems like a no brainer, right?
Investing also has a significant liquidity advantage.
Remember how hard it was to get £300 out of your mortgage overpayment pot mentioned earlier? If you’d have invested into a stocks and shares ISA, this is as easy as selling £300 worth of your investments and waiting for the deal to complete. Within 3-5 days the money is in your bank account and can be used for anything from home improvements or holidays to paying the bills in times of job loss.
So the winner is clearly investing, right?
Yes. No. Maybe. Emotions are a big factor in this. People like to be debt free and have the security behind them of finally paying off a mortgage. But in terms of compounding you’re forcing yourself to have to save harder later in life.
- Overpaying your mortgage is very safe but returns little.
- Investing your money is very risky but will likely return a lot more.
Before we get swept away with this, we must remember that the markets are volatile and anything but a smooth ride. In such a short time frame (5 years) there is a 33% chance that we would actually be facing up to a net loss. We may have seen returns of anything between -50% and +150%. Nobody knows. This is where personal risk tolerance and a little bit of logical thought comes into play.
What does Mr Fox think?
This is purely my own opinion, so feel free to disagree. With that said, I believe that in the current environment it makes little sense to commit heavily to mortgage overpayments but some overpayments will always make sense to lock in that guaranteed return we mentioned.
My current mortgage rate is 2.64%. I firmly believe that the markets will return at least 4% over the next decade. 4 is greater than 2.64, so investing more is the logical play for me. I love the fact that I will be able to access the funds if I need to but I acknowledge that overpaying is a wise habit. This means I personally split my savings 90% to stocks and shares and 10% to overpaying the mortgage.
If my mortgage rate rises above my expected market return, I’ll rethink and commit more (perhaps everything!) to overpaying. But in our current environment of rock bottom rates, I won’t be doing that any time soon.