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)
