Most people assume they’ll be better off by paying off their mortgage as fast as possible. They may be emotionally right but financially they’re wrong. I plan never to pay mine off. Here’s why.
“Debt: an ingenious substitute for the chain and whip of the slave driver,” says The Devil’s Dictionary. That is certainly how most people feel about it, and while we don’t have the moral aversion to being in debt that was prevalent in the 1960s, we still feel that debt is oppressive and look forward to being ‘free of debt’.
I say this is confusing cause and effect. Yes, consumer debt like credit cards and personal loans on which you are paying high rates of interest is bad for you financially, so the best thing you can do is pay it off as fast as you can. But long-term debt used to build wealth is totally different.
Gearing is good
Let’s start with the obvious. If you buy a house worth £200,000 with a £100,000 mortgage and house prices rise by 10%, you have not made a 10% profit. You only put up £100,000 of your own money, and on that you have made a 20% profit.
This is the reason that most people have made more money out of property than shares - because their investments in property have usually been financed with borrowed money. I can assure you that if you had had the courage to buy shares with borrowed money, you could have made far more money over every 25-year period since 1900 than you did through home ownership.
So ‘gearing’ - the use of borrowing to generate higher returns - has worked well for us in the home ownership market. And the people for whom it has worked best are those who have steadily increased their level of borrowings to finance the purchase of costlier houses.
If you owned a house worth £100,000 five years ago outright, it would now be worth maybe £200,000. But if at that time you had moved to one worth £200,000 with a £100,000 mortgage, it would now be worth £400,000 and instead of having capital of £200,000 you would have £300,000.
Being swayed by emotion
So gearing is good for accumulating wealth. Why, then, are people so keen to pay off their mortgages? I believe there are several reasons:
• So long as you owe money on it, it’s not really ‘yours’.
• Paying the interest comes out of your bank account now, while any increase in capital arises only when you sell, maybe years in the future.
• By paying capital off the mortgage, you save many years of interest payments and the total amount you save can appear enormous.
• People find it easier to discipline themselves to make extra mortgage repayments than to put the same amount of money into savings plans.
But ask yourself this: would you invest your money for 25 years for a 6% return? I hope not, because history tells us we should earn an average return of 5% a year on top of inflation - whatever the inflation rate happens to be.
Yet at current interest rates, if you pay capital off your mortgage, you are earning an annual return equal to the rate you pay on your loan, which should be around 6%.
Even when it’s bad, it’s good
I have always taken the view that on a long-term basis, I can and should earn more than the rate I am paying on my mortgage. Of course there have been periods when that wasn’t true, but even they are good news once you adjust your viewpoint.
When interest rates rose in the early 1990s and the stock market was low, the money I was putting into shares in savings plans wasn’t earning an annual return of 11% (which was what I was paying on my mortgage), but it was buying more cheap shares - so even though at the time the returns were poor, when share prices went up, the annual returns on those savings soared.
Indeed, by the end of the 1990s, annual returns from regular savings plans in unit and investment trusts reached 15% or more - way ahead of inflation or the average rate paid on a mortgage. So the combination of an interest-only mortgage and a stock market savings plan has strong arguments in its favour.
The reason the ‘interest-only’ mortgage has gone out of fashion is the ‘low-cost with-profits endowment policy’. These mortgage-linked policies, widely sold by banks and building societies in the 1980s, appeared to reduce the risk of investing in the stock market but ended up increasing it and are leaving millions of homebuyers with ‘endowment shortfalls’.
Where endowments went wrong
The buyers of endowment mortgages got the whole concept wrong, because they were advised to pay too little into their savings plans. Here is how to ensure you get it right.
Use a mortgage calculator to tell you what the monthly repayment would be if you had a capital-and-interest-mortgage. Deduct from that the amount you pay with an interest-only mortgage at the same interest rate.
The difference, paid into a regular savings plan each month, needs to earn the same return as the interest rate you’re paying on the mortgage for you to be able to pay off the loan at maturity. A higher rate of return will leave you with a surplus.
Shares beat cash big-time
Since 1900, shares have produced higher returns than cash in about three-quarters of all five-year periods, in 93% of all 10-year periods and in 99% of all 18-year periods, according to the 2007 edition of the authoritative Barclays Equity-Gilt Study. So the odds are stacked in favour of coming out ahead by using an interest-only mortgage and a regular savings plan.
How big a surplus you end up with will depend on how good the investment managers of the funds you hold inside your savings plan are at their jobs. That is why I recommend you start such a plan with a self-select ISA with a fund supermarket like FundsNetwork, so that you can alter your fund choices and, after a few years, build up a portfolio of funds investing in different areas, and can - as the maturity date of the loan approaches - switch to safer funds and even into cash deposits.
You must update your plan
The calculation I described above is only the starting point of a plan to get rich using a savings plan alongside your mortgage. You need to revise it when interest rates change - the big mistake made by holders of low-cost endowment policies was that they never did this.
So let’s assume you have just bought a property worth £250,0000 with a £200,000 mortgage on which you are paying interest only at a rate of 6%. That gives you a monthly repayment of £1,000. With a repayment mortgage it would be £1,289, so £289 is what you sign up for with a monthly savings plan. If it earns the same 6%, at the end of the 25-year mortgage term it will be worth £200,000.
But now imagine that the day after you sign up to this variable interest rate mortgage, interest rates suddenly jump to 7%. What then? Your mortgage now costs £1,167 per month, and on a repayment basis it would cost £1,414. The difference is £247 and that is the amount that should go into your monthly savings plan. Again, if it earns the same as the mortgage rate (7%) it will pay out at £200,000 in 25 years’ time.
Keep revising your savings rate
And what if interest rates were to drop from 6% to 5% the day after you set up your plan? Well, now the mortgage costs you £833 per month, and on a capital-and-interest basis would cost you £1,169. The difference is £336 so you should increase the subscription to your savings plan to that amount.
As you can see from these examples, the two payments offset each other. When interest rates fall, you need to put more into your savings plan, and when interest rates rise you need to save less in this way.
But actually managing your mortgage on this basis with frequent changes of interest rates is a pain in the neck, and I don’t recommend it. Instead, go for a fixed rate interest-only mortgage for at least two and preferably five years. Then you only need review your plan when you remortgage at a new interest rate. Remember to use the remaining term as the basis for the repayment mortgage, so that if you remortgage after five years, you should use a 20-year term (not the original 25) to calculate what a repayment mortgage would cost you.
What’s at stake?
Back in the 1980s, people who had used endowment mortgages ended up with surpluses of 20%-30% of the amount they owed on their mortgages. It could happen again. Assume you earn a greater return on your savings plan than your loan. Then on a £100,000 mortgage over 25 years, my strategy would deliver a surplus after repaying the loan of:
- if you earned 2% a year extra, £36,000
- if you earned 3% a year extra, £60,000
- if you earned 5% a year extra, £125,000
Now you can see why I regard my mortgage not as a cost but as a profit centre. Happy that it is enabling me to make money out of property, I am even happier to use it to let me make an extra profit out of the stock market.
Even more reasons to stay in debt
Here are some more reasons why I don’t plan to pay off my loan.
• Remember the old saying about bank managers and umbrellas. Pay money off your mortgage and then, if you need cash, you have to go and ask for it - and if your circumstances have changed, the lender may say ‘No’. Build up money in your own savings plan and nobody can tell you what you can or can’t do with it.
• By the time the mortgage maturity date arrives, I hope I will have a capital sum larger than the loan and that I will be able to generate annual income from it sufficient to pay the interest. If I can do that, and the mortgage is earning me a profit, why would I ever want to repay it?
• In my old age, I expect my estate will be subject to inheritance tax. So avoiding it will become an issue.
Having a loan on my home and using trusts to pass the same amount of cash onto my heirs will save me (or rather them) a bundle in tax.
When it could be dangerous
Now for some cautions about dealing with your mortgage like this:
• Over any short period, shares may do badly and produce a cash value of your savings plan way below what you’d need in order to be in the same position you would have been in with a capital-and-interest mortgage. So if you may need every penny when you move in a few years’ time, don’t use this strategy.
• Long-term returns from shares are predictable, short-term returns aren’t. So don’t use this strategy unless you have at least ten years to go to the maturity of your mortgage.
• To get a good return, you need to take an active interest in your fund selections and review them regularly. If you’re not prepared to do this, don’t bother.
