It is a recurring question in the world of personal finance, one that is hotly debated by those who blog about financial independence, early retirement, or the quest for mortgage freedom. What is best for you will depend on your personal circumstances, and attitude to risk. Here are some things to consider.
Which one will make me the most money?
Currently most mortgage rates are in the range of 1.1% to about 3% for new mortgages. You may be on a higher rate if you haven’t moved or remortgaged for some time (it’s worth checking your mortgage paperwork to see if you are paying a high rate). When you overpay you get a guaranteed, tax free return of your rate on your money. We pay 2.54% so for every £100 we overpay we save £2.54 in interest. We don’t pay tax on it. There’s no guesswork as to what the financial benefit is, we know exactly before we even pay it.
In contrast, returns from the stock market will not be known in advance. Investing in the stock market involves taking the risk that the companies that you buy shares in will do well and the share value will increase. Nobody knows (although they may claim to know) exactly how much money shares will make (or lose!), so you cannot predict what the return will be.
If you invest in shares in individual companies, they may do amazingly well, or awfully badly. It is much safer to diversify, meaning that you spread your risk by investing in many different companies. Many of those writing about financial independence or early retirement advocate buying index funds. Index funds contain shares of many different companies, so the risk is spread out. Some companies will do well, others will do badly, but the risk of all of them doing badly and you losing everything is small. On the other hand, so is the chance of all the companies doing amazingly well and you becoming rich overnight.
So roughly what kind of return should you expect? From reading around the subject online, it seems that if you are able to buy and hold your funds for a long time (ie. decades), you may expect average annual returns of more than twice what current mortgage rates are, but there are likely to be many ups and downs along the way. The stock market can be unpredictable and volatile at times, and while it can give great returns, it can also result in big losses, particularly if you are talking about a relatively short period of time. If you can buy and hold funds for the long term, however, you are very likely to beat the returns on the low mortgage rates we are seeing at the moment.
What about if I have an emergency?
Shit happens, and while we tend to think it will never happen to us, it is sensible to at least consider the possibility that it will, and have a plan for when it hits the fan. You (or your partner if you have one) may suffer a loss of income, disability, critical illness, or have responsibilities for looking after family members. These things are challenging enough. You do not need the added stress of financial pressures. Overpaying the mortgage, or investing, can provide peace of mind and an invaluable safety net in difficult times, but in different ways.
If you overpay the mortgage you can reduce the monthly payment, which therefore lowers your bills, until eventually mortgage outgoing is deleted completely. This gives you a bit of a safety cushion in the event of a reduced income.
Another option when you overpay your mortgage is to reduce the term instead, officially bringing the payoff date forward. This will mean that your monthly payment will stay the same, but you will build an overpayment reserve, which you might be able to borrow back, or you may be allowed to take a payment holiday. If you are considering overpaying, you should check the terms of your mortgage to see whether you are able to do these things.
If you have money in investments (such as index funds) you can sell some or all of your holdings to get your money back. The risk here is that you may be selling at a loss, or you may have gained a smaller amount than you would have saved by overpaying. The length of time you are investing is important. As mentioned above, holding funds for a long term would tend to easily beat the kinds of mortgage rates we have these days, but if you have an emergency in the first couple of years after investing, and it’s not been a great time for the stock market, you may not have seen returns yet.
The final aspect to consider is the psychological effects of these options during a time of increased stress and financial pressure. Having reduced bills will seem to be a relief, whereas as watching the savings in your investments accounts dwindle will not be much fun.
Which will make me happier and more motivated to save?
Know thyself would seem to be a good maxim to follow here. Are you the sort of person likely to get a (borderline obsessive) satisfaction from ‘beating the banks’ and seeing that mortgage balance come falling down, knowing that you are on your way to not owing anybody anything? Or do you prefer your numbers on the rise? Watching a stash of cash grow and grow may be much more appealing to you. For those money nerds among us, many an enjoyable hour can be had tweaking investments, getting the best returns and making lots of fancy spreadsheets and graphs depicting our growing wealth.
While investing in index funds seems likely to be the better option if you consider the maths alone, in reality human beings are not machines, or calculators, and many other practical and emotional considerations can have an impact on what we decide is best for us.
My own plan for the medium term
Personally, I agree with the opinion that investing is the better option mathematically, if you are investing for the long run and have time to see decent returns. However, for us, there are practical considerations that mean we are choosing to put most of our extra money towards overpayments instead.
My husband and I currently live in a very small (700 sq ft) two bedroom terrace with our three year old daughter and our one year old son. Our son still sleeps in our room but will soon move in to share with his sister. Now, my husband and I both grew up sharing a bedroom and don’t see it as the horrifying prospect that many other parents seem to, but given that they are a boy and a girl we figure they will no doubt want a bit of privacy and their own space once they get older, so we hope to be able to move by the time they are 10 and 8 at the latest.
The problem we have with this is just how difficult, post credit crunch, it has become to get a mortgage. My husband brings the only income into our house, which is a relatively modest £29000 a year. Despite the fact that we have both always spent less than we earned, had saved a decent deposit for a house, and never had non mortgage debt, we struggled to get the mortgage we needed to buy our first family home, even with a 50% LTV! Without overpaying, in 8 years time we are likely to need a mortgage of around £80000 – the same size as the one we took out last year – except that my husband will then be only 18 years away from statutory retirement age. We may struggle to borrow the amount we will need over an 18 year term, but we know from experience that lenders are unlikely to agree on a mortgage which extends past the main earner’s retirement age. Overpaying our mortgage now puts us in a better position to move when the time comes.
Another very important driving factor for us is the wish to have more flexibility when it comes to work and family life. My husband hates his job, but feels stuck with it because his experience and qualifications mean that he is unlikely to get a job paying as much elsewhere without retraining. I would struggle to get a job earning as much as he does, particularly now that I have a three year gap (and counting) on my CV due to staying home with the kids. We need to address the balance of child care and paid work in our family, to make everybody happy.
Ultimately, we want the flexibility to work less, which requires lower fixed monthly outgoings. Overpaying will enable us to move in 8 years. Investing in the stock market may not, as that may not be long enough to give decent returns.
This is the information from my most recent mortgage statement from 31st December 2017
Mortgage balance: £74177
Term remaining: 22 years 3 months
Estimated end date: March 2040
Original end date: March 2041
Mortgage rate: 2.54% fixed until April 2021
Daily interest: £5.18
How much I need to OP to get it paid off in 8 years: approx. £500!
Over to you
If you want to see how much you could save by overpaying your mortgage, or by how much you could reduce your mortgage term, you can have a play around with this mortgage calculator on the Money Saving Expert website.
Anybody else planning to overpay their mortgage rather than invest? What led you to make that decision? Or are there any readers here who have already made this decision? I’d love to know how it worked out, and whether you would do the same again.