Many people’s first response on receiving a windfall is to think about paying a bit off their mortgage. But often this is a bad decision.
I have annoyed many of you before by explaining why I don’t plan ever to pay off my mortgage.
Now I’ll explain why you’ll be better off investing a windfall rather than using it to reduce your mortgage.
Reducing your mortgage could save thousands
To keep it simple, I’ll assume you have a £100,000 mortgage with a 25-year term at an interest rate, currently, of 6%. This is a capital-and-interest mortgage and the repayments are £651.88 per month.
Now you suddenly receive a £5,000 windfall. What happens if you use it to reduce your mortgage to £95,000? Your monthly repayments fall to £619.29. This means that over the 25-year term, your total repayments are £185,787, which is £9,777 less than they would have been on the original £100,000 loan.
So one way of looking at this is that paying £5,000 off your mortgage has saved you £9,777 over a period of 25 years.
Interested in overseas property investment?
But investing could net you twice as much
Now let’s consider what would happen if you invested your £5,000 in an ISA and got a tax-free return of 6% a year on it. At the end of 25 years you’d have £22,325, so the return on your capital would be double what you’d get by paying money off the loan.
Over the long-term, though, it’s likely a stock market ISA will generate a higher return. The average return from shares over the past 105 years has been 5% on top of inflation.
Assuming an 8% annual return, your £5,000 would grow to £36,700 at the end of 25 years. That would leave you with a profit of £31,700 as compared with the £9,777 you’d gain by reducing the mortgage.
And boosting your pension could give you £61,000
But you could do a lot better than that. If you put the £5,000 into your own pension plan, you’d collect tax relief, so you’d end up with £6,250 invested in the fund. Assuming a 6% annual return you’d have £27,900 in the fund after 25 years.
With an annual 8%, you’d have £45,900. You can take up to 25% of the pension fund as tax-free cash, and a quarter of £45,900 is £11,475 - so you could take a cash sum greater than the benefit you gained over 25 years by paying £5,000 off your loan and still have £34,400 in the pension fund to generate extra retirement income for you.
And if you pay income tax at 40%, then the tax relief results in you having £8,300 in your pension fund, and after 25 years you’d have £37,000 at 6% or £61,000 with an 8% annual return.
Don’t be financially dumb
Despite all this, which clearly shows it’s better to invest the money than use it to cut the debt, most people who get windfalls and have mortgages do use them to pay off their loans. As you can see from these figures, that’s financially dumb. So why do people do it? I think these are the main reasons:
• Over the short term the value of the capital invested in the ISA or pension could fall.
• The saving in the monthly repayments is a here-and-now benefit while the capital gain from investing is far in the future.
• By reducing the debt, you feel closer to really owning your home.
None of these are valid reasons for paying off the debt.
• You are investing for a term of 25 years and there has never been such a period when investing in shares did not produce massive profits as compared with any other form of investment including residential property.
• What will you use the £32.59 reduction in the monthly mortgage outgoings for? If you actually saved it on a monthly basis, then at a 6% return you’d have £22,600 at the end of the mortgage term. But will you do that or will you simply use the reduction in outgoings to buy more beer, takeaways, etc, etc?
• You own your home already, and you benefit from any growth in its value because your debt is fixed.
Paying off a bit of the debt does not add to the benefit of ownership. The return on the money you use to pay off debt is the rate of interest payable on the debt, and your investments should, in the long term, earn at least 1% or 2% a year more than this.
Shorter investment periods are riskier
Now the numbers I’ve used are over a 25-year term and over such a long period you are virtually certain to benefit in the way I’ve outlined above by investing the cash. But if the remaining term on your mortgage is much shorter, this isn’t so.
So my argument is only valid if the remaining term on your mortgage is 10 years or more. The shorter the remaining term, the greater the risk that at the end of the mortgage term, the capital value of the investments will be lower than the amount you’d have saved by reducing the debt.
But for many mortgagees, investing capital is going to be far more rewarding financially then reducing their debt.
