Investing is all about trading off risk and return. To get high returns, you usually have to risk losing money. Playing it safe means accepting lower returns. And with interest rates at rock-bottom, life has become a lot tougher for conservative investors in recent years. Hold your money in a savings account or government bond and you'll be lucky even to match the rate of inflation, let alone get a real' (after-inflation) return.
But what if there was a way to get a higher return on your savings, with little risk and no tax to pay? Well, there is if you have a mortgage.
With interest rates being so low, mortgage rates have come down too. You might think that with borrowing being so cheap, it's not really worth paying your loan off. And it's true there are some good deals around. Those with plenty of equity in their houses can borrow for less than 2%.
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However, if you have less equity and a bigger mortgage (say 90%-95% of your house's value), you will typically have to pay rates of 4% or more. In that case, overpaying begins to look a lot more attractive than a savings account. There's also a lot less risk of sleepless nights than with the stockmarket.
When overpaying makes sense
If you struggle to meet your monthly mortgage payments, or need cash for something else, then overpaying a mortgage is obviously not for you. But if you have spare money to invest, then it's something to consider. By paying more than your usual mortgage payment each month, you reduce the size of the loan outstanding. This means you pay less interest next month, and can pay off your mortgage faster and live rent-free earlier than you thought you could.
The savings on interest payments you make are equivalent to saving tax-free. So if your mortgage rate is 4%, any overpayments give you a clear return of 4%. To get that return after tax you would need to earn 5% before tax as a basic-rate taxpayer (20% tax) or 6.7% as a 40% taxpayer. Where can you get these sorts of returns without taking a lot of risk these days?
The great thing about overpaying your mortgage (as with any debt repayment) is that the savings compound for as long as you have the mortgage (the more quickly you pay off the interest on the loan, the less interest you'll have to pay overall). Yes, there is a risk that a drop in house prices will reduce the value of your equity (your equity is just the value of your house, less your outstanding mortgage). But you will still be better off than you would have been if you hadn't made the overpayments. And if the value of your house doesn't fall, overpaying will increase the level of equity in your home. This is especially true in the early years of a mortgage, when most of the monthly payments are made up of interest rather than a loan repayment.
Building up equity may even allow you to get a cheaper mortgage a few years down the line, as lenders will see you as a less risky proposition. It will also reduce the risks of suffering negative equity (when your mortgage loan is greater than the value of your house) if the housing market crashes.
It's also safe to assume that interest rates won't stay low forever. By overpaying and cutting your debts, you are ensuring that your mortgage payments will be lower than they would be when rates rise. But overpaying makes even more sense if interest rates go up, as your tax-free savings will be even bigger as rates rise.
Things to consider
There are a few things to be aware of. Firstly, before you decide to overpay, make sure you won't incur any penalties from your provider. Secondly, consider liquidity. Overpaying your mortgage might pay more than your savings account, but getting hold of the money if you need it might be a problem. If you are worried about having money tied up in your house, consider an offset mortgage (where the amount of money in a savings account reduces the value of your mortgage) where the overpayments can be kept on hand if you need them.
How it works
Let's say you buy a house for £300,000, with a £30,000 deposit, and a £270,000 mortgage (90% LTV) at an interest rate of 4%.
|£300 per month||£382,327||18 years six months||£112,327|
|£960 per month||£339,552||11 years 11 months||£69,552|
That gives a monthly payment (assuming a capital repayment mortgage) of £1,425. Let's say you can afford to pay £300 more (£1,725) and maintain that every month. If interest rates stay the same (a big if), you could pay off your mortgage six and a half years early, and save over £45,000 in interest, compared with having a mortgage for 25 years.
A really aggressive strategy if you could afford to would be to use your Isa allowance (£960 a month) to pay off your mortgage instead. Here you could pay off your mortgage in less than 12 years and save almost £88,000 in interest tax-free.
Phil spent 13 years as an investment analyst for both stockbroking and fund management companies.
After graduating with a MSc in International Banking, Economics & Finance from Liverpool Business School in 1996, Phil went to work for BWD Rensburg, a Liverpool based investment manager. In 2001, he joined ABN AMRO as a transport analyst. After a brief spell as a food retail analyst, he spent five years with ABN's very successful UK Smaller Companies team where he covered engineering, transport and support services stocks.
In 2007, Phil joined Halbis Capital Management as a European equities analyst. He began writing for Moneyweek in 2010.
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