Should you overpay your mortgage or invest the difference?

Should you overpay your mortgage or invest the difference?

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    If you’re in the fortunate position of having extra cash, you may be wondering if paying a lump sum off of your mortgage is worth it or whether you should put the spare cash into an investment. As interest rates rise, it’s a dilemma for many.

    Deciding between overpaying your mortgage or investing depends on several factors. Mortgage overpayments mean you’ll pay less interest and shortens the loan term, providing long-term savings. Investing, on the other hand, offers growth potential and diversification.

    Using your spare cash to overpay your mortgage means you can potentially save tens of thousands of pounds in interest payments and shave years off your mortgage term, allowing you to pay off your mortgage early.

    Whereas investing spare cash can potentially yield higher returns over the long term. Money invested in the stock market, for example, has historically provided higher investment returns than the interest rate on mortgages/savings accounts and savings interest.

    Before you make a decision, it’s vital to consider your financial goals, risk tolerance, the equity in your home, interest rates, and the tax relief implications before making a decision. If you need guidance, then please contact the experts at Heritage Financial Planning.

    If I overpay my mortgage, how does this work?

    By reducing your mortgage debt, you can either:

    1. Reduce your monthly repayments
    2. Maintain your overpayments but reduce your mortgage term

    If you can afford to do so, then the second option may be best, as reducing the mortgage term allows you to maximise interest savings.

    Do you have to make a mortgage overpayment every month?

    No, it’s not necessary to make mortgage overpayments every month. Most lenders will allow you to make overpayments at any time on a voluntary basis.

    Some lenders may have restrictions on the amount or frequency of mortgage overpayments, so it’s important to check the terms and conditions of your deal.

    A quick lowdown on mortgages

    Mortgage products are usually based on various Loan to Value (LTV) ratios. LTV is the amount of debt in relation to the property.

    For example, a property valued at £250,000 with a mortgage of £200,000 has an LTV of 80%.

    The higher the LTV, the higher the lender will perceive the risk, so most lenders will charge a higher interest rate in compensation.

    Mortgages and the corresponding LTV often go from 95% down to 60% at 5-10% increments. At 60% LTV, the best mortgage rates become available.

    So, when weighing up mortgage overpaying versus investing, consider if overpayments will move you into the next LTV bracket. This would be particularly useful if you were remortgaging in the near future.   

    If you overpay your mortgage and go from an LTV of 85% down to 75%, all things being equal, you could benefit from a better interest rate and lower monthly payment.

    The mathematics of mortgage overpaying vs investing

    From purely a numbers perspective, the decision to either make mortgage overpayments or invest comes down to the calculated ‘spread’, i.e. the difference between your expected investment returns and the interest rate on your mortgage.

    Let’s look at an example.

    Assuming a reasonable and conservative forecast for the global stock market at 7% per year, the calculation would be:

    Spread = Expected return on the stock market – your mortgage interest rate

    If your mortgage rate is going to be less than this, then mathematically, at least, you would be better off by the spread of the difference between the expected return on the stock market and your mortgage rate.

    However, we must stress that this is purely on the numbers – we are not robots after all, and the answer is not black and white.

    Advantages to mortgage overpayments vs investing

    Peace of mind

    The idea of being mortgage free is alluring. Paying off personal loans and your mortgages can be a weight off your shoulders and help you sleep better at night. The significant monthly saving could give you more breathing room or more cash to invest into a private pension or simply to enjoy life. Even if you were to lose your income, your monthly expenditure would likely be manageable.

    Savings on interest payments

    Another advantage of mortgage overpayments versus investing is that it would reduce the term, which reduces your interest payments.

    Let’s look at an example:

    Bob has a £200,000 mortgage over a 30-year term and is paying interest at a rate of 3.50% throughout the term (unlikely, but let’s assume it for the sake of simplicity in this example).

    He is considering regular overpayments to his mortgage, which would reduce the term to 20 years.

    Term  Average monthly payment £200,000 mortgage Interest payable Total  
    30 year mortgage£898£200,000£123,440£323,440
    20 year mortgage£1,160£200,000£78,459£278,459

    The effective overpayments of £262 per month would help Bob be mortgage-free 10 years earlier, saving him £44,981 in interest payments.

    Forced saving

    As it is relatively difficult to take the equity out of your home, overpaying the mortgage can be a good idea from a behavioural point of view for those who are ‘spenders’. Overpayments effectively become a method of ‘forced saving’. After all, taking money out of your home is much more difficult to raid than your savings account to pay for a holiday to Spain!

    The effective overpayments of £262 per month would help Bob be mortgage-free 10 years earlier, saving him £44,981 in interest payments.

    Disadvantages of mortgage overpayments vs investing

    Early repayment charges

    The vast majority of fixed-rate mortgages have early repayment charges. Usually, penalties will be incurred if you repay more than 10% of the outstanding debt in any given calendar year. If you are considering making mortgage overpayments, check the terms and conditions with your lender first. 

    Note that the majority (but not all) of variable-rate mortgages do not incur early repayment charges.

    Your home is an illiquid ‘asset’

    If you are considering mortgage overpayments, it should be with funds other than your emergency fund. It can be difficult to release the equity from your home, and lenders will often only allow you to release the equity from your home for specific purposes.   

    For anyone who has bought or sold a house, you will know the process can take time, with the time from completion to the first listing taking, on average, 6 months

    Neglecting your retirement planning and lack of diversification

    If you neglect your retirement planning in favour of mortgage overpayments, this could have a negative impact on your retirement pot. This could mean result in working longer or a lower standard of living in retirement.

    With the returns on the stock market likely to exceed mortgage interest rates, you could be leaving money on the table by making mortgage overpayments. If you have focused on repaying your mortgage, then your funds have had less time to benefit from compound interest. As Einstein put it:

    “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”

    Overpaying a mortgage vs investing – an example

    Using Bob’s example earlier, if he reduced his mortgage term to 20 years, this would cost an additional £262 per month in mortgage payments.

    We know the saving in interest payments would be £44,981.

    What about if Bob invested the £262 per month for 30 years instead?

    If Bob was to buy a global equity index fund and it grew by 7% per annum, which is a reasonable forecast for the global stock market, over a 30-year term, he would have a fund value of over £317,773.64.

    In this scenario, Bob would be better off investing by £39,314 (£317,773 – £278,459).

    calculating compound interest for investing over time

    What about overpaying a mortgage vs paying off other debt?

    Let’s look at whether you should prioritise paying off your mortgage or whether you should pay off other debt first.

    Firstly, like most things in finance, it depends! Here are a few factors to consider when deciding if you should pay off other debts before overpaying on your mortgage:

    1. Do you have high-interest debts? If you have high-interest debts, such as credit card debt, it would probably be more financially beneficial to pay off these debts first. This is because the interest rate on a credit card is generally a lot higher than the interest rate on a mortgage, and so you would save more money in the long term.
    2. Do you have a large enough emergency fund? It’s important to have cash savings to cover unforeseen emergencies and expenses. If you do not have an emergency fund, it may be more beneficial to focus on building one up before making additional payments on your mortgage. A rule of thumb is to hold 3 months’ expenses in cash as an emergency fund.
    3. Is your home in need of maintenance and repairs? If your home is in need of some TLC, it may be more beneficial to prioritise these expenses before making overpayments on your mortgage. Neglecting necessary repairs can result in much bigger and more costly problems later down the line. While maintaining your home not only will make it a nicer place for you to live but will also help increase your home’s value over time.

    Typically, it is a good idea to prioritise paying off any high-interest debts and building a suitable emergency fund before making additional payments towards your mortgage.

    When should I invest?

    As Einstein told us, compound interest, i.e. the interest earned on an investment which is reinvested to generate additional earnings over time, is a powerful thing. So it is generally best to invest sooner rather than later. The earlier you invest, the more time your money has to grow and compound.

    FAQs about overpaying your mortgage

    If you’re looking for more information on overpaying your mortgage, check our frequently asked questions below, or contact us today:

    Does overpaying your mortgage affect your credit score?

    No, overpaying your mortgage does not have a negative impact on your credit score. In fact, consistently making overpayments on your mortgage may help improve your credit score over time, as it demonstrates financially responsible behaviour and reduces your outstanding debt.

    Are there tax implications to overpaying your mortgage?

    There are generally no tax implications to overpaying your mortgage. However, if you have a buy-to-let mortgage, overpayments may affect the amount of tax relief you receive. This is because you receive a 20% tax credit for the interest element of buy-to-let mortgage payments.

    With regards to investing, you may have to pay Capital Gains or Income Tax on your investment returns.

    Will interest rates affect my mortgage overpayments?

    Interest rates can affect the impact of mortgage overpayments, yes. When you make an overpayment, the extra amount is applied to your mortgage balance, which reduces the amount of interest you pay over the life of the loan. However, if interest rates on your mortgage increase, your regular mortgage payments will also increase, which may reduce the impact of any overpayments you make.

    Thinking about overpaying your mortgage? Get advice from Heritage Financial Planning

    Working out what best to do with your hard-earned cash for long-term benefit is a concern for many. The thought of making a wrong move to the detriment of you and your family is naturally unnerving. Heritage Financial Planning exists to alleviate those worries and guide you on the right path to maximising your personal wealth.

    Our close-knit team of financial advisors will go to great lengths to understand your individual circumstances and goals. As independent advisors, our only motivation is to help you achieve the best return on your investment.

    For peace of mind when planning for your future, contact Heritage today. To arrange a free initial consultation, please fill in our contact form.

    Conclusion

    When it comes to overpaying your mortgage versus investing, there is no right or wrong answer; it all very much depends on your individual circumstances. When making your decision, consider your interest rate and mortgage term, your tolerance for investment risk and market volatility, your investment experience and close to retirement you are.  

    *Please note that your home may be repossessed if you do not keep up your mortgage repayments. 

    The value of your investments can go down as well as up, so you could get back less than you invested.

    The information contained within this article is for guidance only and does not constitute advice which should be sought before taking any action or inaction.

    Alex Norman-Jones​

    Alex Norman-Jones​

    I am one of the founders of Heritage and I am highly motivated to deliver bespoke financial planning solutions to my clients.

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