Should you overpay your mortgage?
Mortgage rates have gone up a lot in recent years, so many of us are now overpaying our mortgages to reduce the overall balance and monthly payments.
Is this a good idea? Mostly not. For most of us, if your goal is maximising your personal wealth, then overpaying your mortgage will be a negative. (note the goal of ‘maximising your personal wealth’- is a purely financial goal and doesn’t account for the psychological benefit that people get from having little or no mortgage).
Why is it probably not a good idea? Because a mortgage is the cheapest form of money any of us will probably ever get (for more background on why the ‘cost of money’ is different for mortgages, savings, investments etc, click here).
For each of us, our overall financial position is a direct result of how much money we either have outright, or have access to. So paying back the cheapest source of money you can get is typically not the best way to maximise your wealth.
Step 1: Pay other debts first
First things first, before you even think about overpaying your mortgage, the best place to start is probably to make sure you’ve paid off your other interest bearing debts. You want to reduce the expensive debts before you remove the cheap ones. Personal loan, credit card, car finance etc- all will have a higher interest rate than a mortgage and so need to be removed first.
Once all the other debt is gone, and you’re now considering paying down your mortgage, your next question (as with any financial decision) should be one of opportunity cost: ‘what else could I do with this extra money I’m considering overpaying my mortgage with?’
Here we get into the meat of it, and find that there are two main problems with overpaying your mortgage:
Problem #1: Flexibility
One of the biggest unseen costs of paying down your mortgage is that you lose access to your own money. If you overpay your mortgage by £500 a month for 3 years, that’s a total of £18,000 that you’ve saved, but also locked away somewhere you can’t access it.
It’s your money (you earned it, paid taxes on it), but you now can’t get at it. You can’t withdraw it if you need it for an emergency, you can’t move it somewhere else if you get the opportunity so save/invest somewhere else to earn a higher return. The only way to access your own money now is to do a remortgage or an equity release- at which point you’re now going to have to pay interest just to get access to your own money!
Problem #2: The maths
If you take out a £400,000 25 yr mortgage at around 4-5% (and assume for simplicity rates stay the same of the mortgage), your payments will look something like this:
In year one, around two thirds of your payments goes to just paying interest. By year 20, two thirds of your monthly payment goes towards your principal.
Let’s say you are considering overpaying your mortgage by £200 a month to shorten your mortgage. When you add up all those extra £200’s, they total £51,000 by the time you clear your mortgage. This is the impact:
So over paying by £200 a month you’ve shortened your mortgage by around 3 and a half years, and saved yourself around £64,000 in interest. That’s a significant amount.
But what else could you do with that same £200 a month? For a very simple comparison, assume you invested £200 in a stock index tracker, which have averaged 8-10% a year over a very long time.
After the same 21 yrs, your investment pot would’ve grown to somewhere in the region of £130,000-£170,000. Let’s use the £130,000 to be conservative. If do this in an ISA, there will be no income or capital gains tax to pay (same as on the house if it’s your primary residence).
Even if you’re maxing out your ISA allowance elsewhere and you simply make these investments in a normal taxable investment account, after tax you’re looking at £93,600 if you’re paying 28% capital gains, or £106,000 at 18%. The overall comparison is:
In every scenario your financial situation is far better if you invest vs overpay your mortgage. If you can do it tax free in an ISA you’re going to find yourself £65,960 better off compared to overpaying on your mortgage.
Plus, you’ve had complete access to that money the entire time should you ever need it. Being able access these funds in case of an emergency (or perhaps just a better saving/invest opportunity) is hugely valuable.
What if you’re older and have only got a few years to run on your mortgage?
In this scenario, overpaying may make sense as you might not want to take investment risk on your money. If that’s the case for you- compare your potential interest rates on savings products to your mortgage rate. If you can’t generate more on your money than you’re still being charged on your mortgage, then it can make sense financially to overpay or clear your mortgage entirely.
Why is overpaying so popular when for most of us it doesn’t make financial sense?
There are a few main reasons:
Most of us don’t know how much better off we’d be by doing something different.
Psychologically people want to remove their debt, so would rather do that than invest.
People don’t consider the cost associated with losing access to their own money.
The investment returns aren’t guaranteed- you may do worse or better than above.
Many people know they don’t have the discipline to keep saving consistently for a long period, but bundling it into a mortgage makes it easier as that money is locked away from them.
That final point is an interesting one and creates a significant benefit for many people by enforcing discipline. Without doubt locking your own money away and having to pay interest if you ever want it back is illogical, but for many of us it can have a benefit in terms of enforcing discipline. There are times when even the most disciplined among us might find it too easy to dip into pots of money if they’re easily accessible. Do that a few times over the years and your excess returns will deplete and you may have been better off paying your mortgage down overall anyway.
This is an important consideration, and is why the decision to overpay or not is ultimately very personal. If you are confident in your ability to create a plan and stick to it, you’ll probably be better off financially by not overpaying your mortgage. Placing the savings/investments in accounts like ISAs where there’s a disincentive to withdraw can help to create some discipline and controls.