To pay off the mortgage or to invest? That is the question.
It’s an often debated question in the world of financial independence and one thats been done to death in blogsphere several times over.
In this article I won’t go in depth into all of the pros and cons of each side of the argument but instead focus on describing what I do and why. If you’re currently debating this issue internally here’s a good look at the subject from the ever reliable Monevator. For the lazy amongst you here is a quick summary:
Arguments to Overpay Your Mortgage
- It is equivalent to investing with a guaranteed rate of return
- No need to worry about volatility of your investments
- It reduces (and ultimately eliminates) what is likely your largest monthly outgoing making retirement more possible
- It gives you a nice warm fluffy feeling inside when you see how much interest you have saved yourself over the term of your loan
- There is no need to worry about what stock or fund to invest in, just send any spare cash to the mortgage company
- Investing in your home is free from capital gains tax should you decide to sell and take profit in the future so you are technically investing in a tax wrapper of sorts
Why you should invest instead
- Long term equity returns are almost certainly higher than the current rate of interest you’re paying on your mortgage. Why reduce a liability at 2% when you can earn 7% on the money instead?
- Having all your financial eggs tied up in one lump of residential property might not end well (see Ermine’s experience here as an example). Instead it’s better to diversify into stocks and bonds.
- Equity returns tend to be better the longer you’re in the market so the earlier you start investing instead of paying a mortgage the more benefit you’ll get
- If you hit a hard patch you can always sell of some investments to keep things ticking over, not so easy to do with a house
- It’s far sexier than overpaying the mortgage and is guaranteed to impress your friends!
My Solution
Like most things financial a balanced solution is usually best for me. I am currently taking the hybrid approach, or at least I was.
For the last few years I’ve been socking away cash into investments as well as overpaying mortgages. Given the long equity bull market we’ve had for the last few years I would probably be richer now if I had ignored the mortgage and gone all in equities. However the psychological pull of taking advantage of a low interest rate environment to make huge dents in my mortgage was too tempting.
Since moving recently our mortgage has been an offset savings mortgage on which the rate I currently pay is 1.79%. This beauty of a loan enabled us to navigate the risky path of buying our new property before selling the old one at very little cost.
Our loan is pretty much completely offset by the linked saving account for the time being, until planned works begin. This means that the mortgage currently behaves exactly like a giant (and currently cheap) overdraft facility. In the wrong hands this could be a very dangerous thing but thankfully under the money tree we treat access to such a large credit facility with the respect it deserves.
While I try and not time the markets the offset mortgage gives me more flexibility to choose when to invest and when to leave capital offsetting at 1.79%. If I have some cash spare and markets have just dropped a few percent I’ll usually invest. If they’re once again breaking record highs for no apparent reason I might opt to park the cash in my offset savings account.
It is essential if I am investing that it is done in tax efficient wrappers so I get the highest possible returns possible.
Fill ISA Allowances Before Anything Else
The current £20k ISA allowance is currently the most important tax break on offer to me. Given my wife and I are still reasonably young1 and both still working, being able to sock away £40,000 per year into investments that are free from future income and capital gains tax is far too good an offer to pass up.
As the ISA allowance has risen (dramatically) over the last few years, so has their importance in our retirement planning. Once we’re done with work, ISAs should provide us with a meaningful slice of regular tax free income for the rest of our lives. They’ll also give us the option of lump sum withdrawals free from capital gains tax.
Given the above, filling our annual ISA allowances is a key priority each April. If we don’t have the cash at hand to do it I will more than happily ‘borrow’ it from my mortgage offset account at 1.79% for the short term as and when good investment opportunities present themselves.
Pension Contributions Give a Tasty Return
As a higher rate tax payer, additional pension contributions currently offer a tasty incentive in the form of a 40% tax break. An instant return of 40% is a damned sight higher than 1.79% that I am getting by overpaying my mortgage.
Before remortgaging to stuff our pensions full I need to bear in mind that the future returns of that money invested in pensions is far from guaranteed. It’s susceptible to not only investment returns, but also meddling from the government who can change the rules about when I can access the money and how it is taxed in the future.
Of course as things stand once I reach the appropriate age, the government will let me withdraw 25% of my pension pot tax free. If so inclined I could use such a lump sum to pay off any existing mortgage loan (residential or buy to let) if required. I expect the mortgages to be long gone before I get that tax free lump sum but it’s a nice option to have if i want to take it up.
So I will continue to make some additional pension contributions when I see fit or when the market looks cheap without going overboard. I need to bear in mind the dreadfully complex tapering of pension contribution tax relief and lifetime allowances. As I get nearer to being able to access my private pension I’ll ramp up additional contributions as the regulatory risks should be less uncertain.
Notes:
1Clinging on to our 30’s for dear life ;0)
A very clear and convincing analysis especially if you are UK resident. That ISA allowance is a game changer.
However I find this choice depends on your emotional and lifestyle priorities too. A bit like most peoples emotions in regards to money lost or gained. Basically it is better not to lose money you already have than to gain money you do not have. Risk.
Recently at work my employer unilaterally changed our working week from 43 hours to 60 hours for a 7% pay rise. Jobs are hard to find so we are more or less stuck with this. However a sweetener was that job sharing was widely introduced. As someone who only has a small mortgage left I jumped on this straight away as 60 hours a week in my line of work is absolutely soul destroying and almost guaranteed to lead to depression and health problems. Those who still have big mortgages are stuck on 60 hours a week and you can see them greying, ageing and falling into depression almost in real time. They are trapped. My point is that not being bound by your mortgage has immediate practical benefits in terms of your psychological freedom of action because your regular cost of living is low and you feel secure. If all your wealth is tied up in volatile stocks and bonds you can never be sure it will be there to deliver your freedom when you need it most.
Tim,
Absolutely, attitude to risk and psychology both play a huge part in this conundrum and explain why there is not right answer.
Wow, moving to a 60 hour week. Can I ask what line of work you are in? Unlike others it sounds like you’ve got a great deal, presumably working 30(ish) hours a week with small outgoings….sounds like you’re half way to FI already.
Just returned to check out your mothballed blog again and found my post here from two years ago. I somehow missed your response to it. I am a mining operator in a Western Australian iron ore mine – so operating the production machinery. A very different style of work to what most people in the UK would be used to with the exception of North Sea oil field workers. We fly in and out to work as the mine is about 1500kms from Perth. It used to be 7 days on and 7 days off – a great way of life and well paid. Perfect for pursuing FIRE. However they changed the roster to 14 days on (actually 7 days followed by 7 nights) and 7 off. A huge destruction of our quality of life. We work 12.5 hour shifts so exhausting. I took the option to jobshare and work 50% of the full time hours so now I work 14 days on and 28 days off! A great way of life as I travel abroad for the 4 weeks off but not so good financially as my gross pay is halved. Yes I have done very well financially out of mining and I am financially secure if not fully independent quite. However because of the changed circumstances I am changing focus to enjoying the here and now more. Also as I approach 50 I realise that there are many things I want to do that benefit from relative youth so I am going to grasp the opportunity to do those things before I am old.
Hey UTMT, good to see you back posting.
Looks like a solid plan, in hindsight taking your approach would have been the best approach for me too, but…
It turned out my chosen line of work was very unstable, what looked cool in my twenties turned into a ‘mare once I had mortgage and kids. Consequently I spent my thirties stumbling about in a state of (partly justified) paranoid anxiety. Paying off my mortgage was like flicking a switch on that. I think I’d have needed some serious medication to see me through a full term mortgage, particularly through 2008/9.
Hi UTMT, enjoyed your post as always.
My wife and I took the emotionally satisfying route of paying off our mortgage recently.
We had been in the fortunate position to receive some inheritance money, but this left us 50k short. Having weighed up the pros and cons, we decided to cash in our Shares ISAs and pay off the mortgage in full. Many might see this as a foolish thing to do, but our monthly outgoings are now so low that it gives us many more options in life.
Interesting blog and great tips. Can I ask who you got your mortgage with?
Jamie,
Coventry Building Society.
Good article but there isn’t much chance for effective compounding of interest on the pension as per below. If the purpose is just to shield your salary from income tax then that’s fair enough based on your other investment options that are quietly compounding.
“As I get nearer to being able to access my private pension I’ll ramp up additional contributions as the regulatory risks should be less uncertain”