Hello everyone! Today’s post is aimed at those in the fortunate position of having a little extra cash at the end of each month and are thinking about if a good use of it would be to overpay their mortgage.
Unless you have other debts, it may raise a few eyebrows to even suggest not – after all most of this site talks about paying down debt as rapidly as possible so a surprise to conclude anything “other than pay it off right away”.
After all, a mortgage is a form of debt and costing us interest, so why wouldn’t we simply pay it off?
The debate I’m looking to run today is one of a concept economists call “opportunity cost” – what we lose by taking one course of action over another, and I’m going to explain the cases for and against.
As ever – our normal note that we take care with what we write on this site but it is not official “financial advice” and whatever investments and savings you enter need to be right for your circumstances. We always suggest doing your own further research. If you’re in doubt about anything, it’s worth consulting a regulated and reputable financial advisor who can provide tailored advice built for you.
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There’s one case where you definitely shouldn’t overpay your mortgage.
Most of this article is going to come down to elements relating to your personal approach to risk and timings, but there’s one case where the answer is very clear cut. If you have any other types of debt (like credit card debt or a personal loan) that are more expensive than a mortgage, you should prioritise dealing with those debts first
If that’s you, this article helps you manage that debt down that most efficiently (it’s aimed at credit card debt but in practice the principle applies to all types of debt).
Why you shouldn’t overpay your mortgage
Investing money (cautiously) in the stock market instead could provide more than the interest you save
The maths around mortgages mean that it’s possible that investing any spare cash in the stock market could potentially be more beneficial than what you’d save in interest cost by overpaying.
Mortgages in the UK for those with a good LTV are generally available in the 2%, or even sub-2% territory. In historical terms, that’s incredibly cheap. (Update: Ok, not any more – with a higher interest rate environment, the amount people have to now spend on servicing mortgage debt has increased considerably).
Let’s compare that to the stock market, and investing in something pretty simple like index funds. Since 2000, the average annual return of the S&P 500 (the main stock market in the US averages out at 8.86%, considerably higher. (That “averages out” element is important and we’ll come back to that on the other side of the argument).
But the gap between the potential return of investing the money, vs. the interest that we’d save with mortgage overpay creates a compelling argument in favour of not overpaying – if the averages play out, we’re likely to be over 6% better off each year.
If we could achieve that additional return consistently, it provides a lot of flexibility in achieving our financial goals. On a pure long term mathematical basis, it makes a lot of sense to invest rather than pay off.
We’d always suggest caution in the form of sticking with the low-risk end of the stock market with this route.
Mortgage debt is both relatively cheap and large, so it can eradicated by inflation over time.
This point is slightly theoretical, as it’s unlikely to be the case at this immediate moment and gets a little technical.
A mortgage is effectively the cheapest debt you’ll ever have – after all, it’s secured against your house and with interest rates at historic lows and in some countries (possibly even the UK) heading into negative territory the costs of a mortgage have quite literally never been lower.
An economic term is the idea of inflation, which relates to the value of money over time. I always think a Cadburys’ Freddo (a small chocolate frog for those unfamilar) is a good example of this – I wistfully remember when you could pick up one of these for a mere 10p. As of today, the cost is a relatively large 30p. That increase in prices over time across a whole economy is called inflation.
Replace that Freddo with a 200k mortgage. The value of what you’re paying off stays the same – you agreed to repay 200k plus the rate of interest.
At present even with higher interest rates, the rate of inflation for most will be a greater amount that the mortgage interest rate. Whilst it may not feel like it, this means the value of your mortgage debt is being eroded in real spending power terms – actually an argument for not paying off your mortgage whilst this is the case.
Why you should overpay your mortgage
Your investments could turn in a bad market and remove your safety margin
If the stock market simply increased 8.86% every year as per the “pro” argument above it would be an absolute no brainer – you’d invest rather than overpay every time.
However that linear growth isn’t the case – this period also covers the 2008 financial crisis where stock markets absolutely collapsed, and plunged over 30% in value in the matter of a couple of days.
Plenty of people were losing their job in that period as well, meaning a main income stream to cover your mortgage could be cut off. If you had to sell the investments in that period to cover your expenses, you could potentially be forced into a position of selling your stocks having lost money – counterproductive to the whole enterprise.
And let’s not forget that recovery took a couple of years – replacing job and income may not be an instant fix in such scenarios. I’m sounding a bit doomsday now, but I’m do want to emphasise this because we have a bit of a tendency to forget the worst aspects of a recession.
Investment is a great thing in the long term – it can be risky in the short term and you need to be careful how you position yourself.
To overpay can be safety first
For some people there is value in itself of dealing with any debt relating to you house first – after all, it’s one of the most important assets you have.
This argument is entirely valid – there’s only one way to ensure your house is never at risk, and that’s to get rid of the debt entirely and to overpay the mortgage gets you there quicker. This simply comes down to personal preference.
Overpaying can provide flexibility via the debt being lower
Life is unpredictable, and there are certain actions where it may be actively helpful to have your mortgage debt be as small as possible.
A good example of this is if you’re looking to move house whilst still within your fixed rate period for a mortgage.
For example in a situation where you’re being forced to sell a house due to unexpected such as a breakup or a death of a partner, having the mortgage be lower may help manage this.
Another example is if moving house during the fixed rate period of a mortgage. Many mortgages allow you to “port” your mortgage across to a new property – but the bank isn’t actually obligated to accept this if you have a change in circumstances, and the mortgage being smaller may increase the chance of acceptance
The theoretical side of investing rather than overpaying make sense, but it’s slightly weighed down by the practical difficulties of potentially hitting a bad time in the markets.
If you’re going down the investing route I’d suggest at the very least making sure you have a significantly large cushion to provide security if you face a change in circumstance and make sure there’s no chance of you missing a compulsory mortgage payment.
As we always advise on this site, you should always be investing for the long haul as well.
And if you’re going down the investing route stick with relative safety – gambling your home to invest in some speculative stocks seems very foolish indeed!
Both sides of the argument have merit though, as long as you do so with care and are comfortable it’s right for you.
If you think we’ve missed a good argument on either side or have further questions about the points here, let us know in the comments – we’d love to hear from you!