MONEY MAT­TERS

We run the num­bers to com­pare the dif­fer­ent sce­nar­ios

Shares - - CONTENTS - Laura Suter, per­sonal fi­nance an­a­lyst, AJ Bell

Should I over­pay my mort­gage or in­vest the cash?

You find your­self with spare cash at the end of the month – are you bet­ter off sav­ing the money or us­ing it to pay down your mort­gage debt?

It’s the ques­tion that home­own­ers are faced with: to save a pot or re­lieve them­selves of debt sooner. Typ­i­cally the adage is to pay down any debt be­fore you save money, but mort­gages are of­ten con­sid­ered dif­fer­ent to typ­i­cal debt. Here we at­tempt to an­swer the co­nun­drum.

WHAT ARE YOU SAV­ING FOR?

Firstly, if you have money to spare each month you need to make sure that you use it to pay off ex­pen­sive debt, such as clear­ing credit card bills or store cards charg­ing high in­ter­est rates.

Once you’ve cleared that – or if you didn’t have any debt in the first place – you then need to build up a cash buf­fer to cover your ex­penses if an un­ex­pected event hap­pened, such as ill­ness or los­ing your job.

The rule of thumb is to have be­tween three and six months’ es­sen­tial ex­penses cov­ered, such as your mort­gage, heat­ing and food bills.

As­sum­ing you’ve sorted all of this, you then face whether it’s bet­ter to save or make ex­tra pay­ments to­wards your mort­gage. In part, it re­ally de­pends on what you are hop­ing to do with your sav­ings.

If you have a par­tic­u­lar goal that you want to achieve, such as buy­ing a new car in two years be­cause yours is go­ing to conk out, or sav­ing for school fees when your child starts their ed­u­ca­tion in three years’ time, then you are prob­a­bly bet­ter off sav­ing money for that, rather than lock­ing it up in your mort­gage.

If you’ve al­ready met those sav­ings goals – or you’ve got spare cash even af­ter sav­ing for them – then you can con­sider over­pay­ing your mort­gage.

First, you need to check that your mort­gage com­pany al­lows you to over­pay some of your mort­gage. Most will al­low you to re­pay up to an ex­tra 10% of the mort­gage amount each year, but any­thing above this may re­sult in an early-re­pay­ment charge that of­ten makes it cost pro­hib­i­tive.

Some, such as Tesco Bank, al­low you to re­pay 20%, while oth­ers al­low un­lim­ited re­pay­ments (although these are rare and you may end up pay­ing a higher in­ter­est rate on your mort­gage in re­turn for this flex­i­bil­ity). Def­i­nitely check whether your mort­gage com­pany al­lows early re­pay­ment, and how they cal­cu­late the 10% fig­ure.

An­other im­por­tant fac­tor to check is that your re­pay­ments go to­wards re­duc­ing your mort­gage debt, rather than re­duc­ing your monthly pay­ments.

HOW THE SUMS ADD UP

Whether you’re bet­ter sav­ing the cash and in­vest­ing it de­pends on your mort­gage rate. Rates are at his­toric lows at the mo­ment, mak­ing bor­row­ing in­cred­i­bly cheap for home­own­ers. The ac­tual rate you pay de­pends on the amount you bor­row ver­sus the value of your home (or your loan-to-value ra­tio), your credit rat­ing and whether you have shopped around for a bet­ter rate.

We’ll as­sume you are a savvy home­owner who has locked in a low rate. For a £200,000, 20year re­pay­ment mort­gage on a £250,000 prop­erty you would pay around 2.2% for a five-year fixed rate or 1.5% for a vari­able rate, which rises when the Bank of Eng­land’s base rate in­creases.

We’ll also as­sume that your provider al­lows you to re­pay 10% of your mort­gage amount

each year – start­ing at £20,000 – and that by do­ing so you cut your mort­gage debt, not your re­pay­ments.

Af­ter seven years (with the above £200,000 mort­gage and as­sum­ing a con­stant in­ter­est rate of 2%) you could have re­duced the mort­gage bal­ance to £63,715 via the over­pay­ment route.

We as­sume you have bud­geted £20,000 each year for the over­pay­ment, even though the mort­gage over­pay­ment amount will de­crease each year as you’re pay­ing 10% of the out­stand­ing bal­ance – so you pay less as the mort­gage bal­ance falls. For ex­am­ple, in year two you pay £17,179 and then £14,710 the fol­low­ing year.

Any un­used money from your £20,000 an­nual bud­get is put in a cash sav­ings ac­count each year earn­ing 2.5% in­ter­est. Af­ter seven years this cash bal­ance plus in­ter­est is worth £67,010. This money is used to clear your mort­gage (and we as­sume you don’t have to pay any early re­pay­ment charge).

This would cut 13 years off your mort­gage term and would save you £27,743 in in­ter­est pay­ments, com­pared with a sce­nario where you made no over­pay­ments.

Any cash you would nor­mally have used for mort­gage re­pay­ments could, from this point, go to­wards your pen­sion or other sav­ings.

What do you end up with if you’d in­vested the en­tire mort­gage over­pay­ment money in­stead? De­ter­min­ing the re­turn you’re likely to get from in­vest­ing is tricky, and de­pends on how risky your in­vest­ment is and how long you’re in­vested.

On av­er­age, ac­cord­ing to Bar­clays’ Eq­uity Gilt study, you can ex­pect to get re­turns of 5.6% over the long term from the stock mar­ket – although this fig­ure is ‘in­fla­tion ad­justed’ and so is lower than the head­line fig­ure would be.

If you in­vested that same £20,000 each year, as­sum­ing an an­nual growth rate of

5%, you would end up with just over £167,000 at the end of the

IN­VEST RATHER THAN OVER­PAY MORT­GAGE

seven-year pe­riod you would have been over­pay­ing on your mort­gage.

This would be made up of de­posits of £140,000, with around £27,000 of in­ter­est on top. In this sce­nario you would have been slightly bet­ter off over­pay­ing on your mort­gage, as the in­ter­est saved on the mort­gage is greater than the money gen­er­ated by in­vest­ing.

WHAT ABOUT TAR­GET­ING HIGHER RE­TURNS?

If you were will­ing to put the money in higher risk in­vest­ments, and we as­sume a 7% re­turn, you would end up with al­most £180,000 at the end of the same pe­riod – with £40,000 of that be­ing profit. In this sce­nario you would end up more than £12,000 bet­ter off by in­vest­ing.

How­ever, in­vest­ing clearly in­volves some risk, and you could lose money dur­ing this pe­riod. If you were more risk averse and wanted to de­posit the money in a bank ac­count you could ex­pect to get around 2.7% at the mo­ment on a fiveyear fixed-rate bond. As­sum­ing this as a con­stant rate for the seven years, you would have just over £154,000 – a £14,000 gain and so you’d be worse off than over­pay­ing your mort­gage.

OVER­PAY MORT­GAGE AND IN­VEST

What about if you hedged your bets and put half the money into your mort­gage and half into in­vest­ments? By over­pay­ing by £10,000 a year on the same mort­gage sce­nario as above you’d end up pay­ing off your mort­gage af­ter 10 years, and would save £21,060 in in­ter­est.

Along­side that, your £10,000 an­nual in­vest­ment would gen­er­ate £29,160 profit at a 5% rate af­ter 10 years, or £43,349 at a 7% an­nual re­turn. Be­cause the money is in­vested for longer, the re­turns are com­pounded for longer, sig­nif­i­cantly boost­ing your pot.

By tak­ing this ap­proach you’d end up around £8,000 bet­ter off in the 5% in­vest­ment sce­nario, or £22,000 bet­ter off at 7% re­turns. It’s worth not­ing that be­cause you’re pay­ing in for 10 years you need to put in more money than in the pre­vi­ous sce­nario.

It’s fair to as­sume that even af­ter you’ve paid off your mort­gage, you’re go­ing to have cash to spare that you could save and in­vest. So what about if we worked the fig­ures out over 20 years?

Some­one who saved that £20,000 a year over 20 years would end up with a pot of £679,000 as­sum­ing a 5% rate – hav­ing earned £279,000 profit. At a 7% in­ter­est rate this would rise to £450,678 profit. In the cash sce­nario they would have gen­er­ated £129,000 of in­ter­est.

If that same per­son had spent the first seven years over­pay­ing their mort­gage, and ul­ti­mately pay­ing it off, and then in­vested the cash, they would have profit of £103,783 at a 5% rate, or £157,929 at 7%. In the cash sce­nario they would have £51,051 in­ter­est.

If you add that to the £27,743 you would have saved in mort­gage in­ter­est by pay­ing off your mort­gage early, you still don’t come near the re­turns from the in­vest­ment sce­nario.

WHAT ABOUT SAV­ING FOR LONGER?

Source: AJ Bell

Source: AJ Bell

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