You could use the latest cut in mortgage rates to overpay your mortgage term. You’d pay your loan off early and save a packet in interest, so surely this has to be the right decision? No, it’s not - but your mortgage can make you rich.
Most journalists simply convey the conventional advice that paying off your mortgage faster is a Good Thing. So they recommend ‘overpaying’ your mortgage. The result is that you can knock about 5 years off its term and save thousands in interest. It’s a slam-dunk!
But go through the figures carefully and you’ll see this doesn’t necessarily make sense. In fact, for most people who have over 15 years left on their loan, it’s more advantageous to use the money another way.
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A simple example
Let’s assume you have a £100,000 loan outstanding with a term of 25 years. Of course most people don’t, but if I take other figures they will be more complicated. You can work your own out using a flexible mortgage calculator.
I’m going to assume that you have a tracker mortgage on the terms of ‘base rate plus 1%.’ That means you were paying 5.5% and after the latest big cut are now paying 4%. Your monthly repayments were £614 per month and are now £528 per month.
Now what happens if you use some of that £86 per month saving to overpay your mortgage? I’ll assume you use £75 per month, so that you pay £603 per month instead of £528 to the lender. The result is that you will pay your loan off after 20.2 years instead of 25, and that the total cost of repayment will fall from £158,300 to £145,800.
So you will save £12,500 in interest as a result of making total payments (20.2 years at £75 per month) of £18,180. Why have you paid £18,180 just to knock £12,500 off the total cost of repaying your £100,000 loan? Because you have accelerated the repayments, so that each of your new monthly payments contained more capital. Being ‘free of debt’ almost 5 years early will strike most people as a big advantage.
Unfortunately this is based on the feeling that it is good to be ‘free of debt’ without giving any thought to the actual return on your money.
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What do we think of 4%?
Imagine someone was asking you to save towards your retirement, and said: ”It’s a pretty good plan - you get 4% interest”. How would you respond? I hope you would say “Rubbish!” because over a 25-year term a 4% return is rubbish. On the basis of history you would be mad to save over 25 years with a 4% return.
The average you can expect over that period is about 5% on top of inflation, so if you were to assume an average inflation rate of 2% you could expect to get a 7% return on your savings if they were invested in the stock market. So why put extra into paying off your mortgage? If you are saving interest at a rate of 4% on this money, then you are earning a return of 4% on your money. How much sense does that make?
Suppose instead of overpaying your mortgage by £75 per month you put the £75 into a regular savings plan linked to shares. After 20.2 years, assuming a 7% annual return, the plan would have a cash-in value of £40,000. Your outstanding loan at that point, assuming you’d kept your monthly repayments at £528 per month, would be £20,000, so you could pay off the rest of the loan and have £20,000 in the bank. In other words, you’d be £20,000 better off than if you’d overpaid your mortgage.
As I’ve shown before in explaining why I won’t pay off my mortgage, the key point is that over the very long term shares have always produced far higher returns than the typical mortgage rate.
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Big profits are possible
And once you have got your head round the effects of compound interest you will appreciate just how much free money is sitting there waiting for you to claim it. I’ve recently given examples of savings plans that have returned between 10% and 25% a year over ten years.
You can work out just how much your £75 per month savings plan would accumulate over 20.2 years at higher rates using this calculator. Be prepared to be surprised. You really could get rich.
So if these big chunks of free money are sitting there waiting to be claimed, why don’t more people take them? Why is it that the newspaper articles will focus on overpaying mortgages and not on savings plans? Why are you reluctant to think about doing this?
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When it’s better to overpay
There are many reasons why people don’t adopt the strategy I’ve suggested. Only two of them are valid:
• You have a remaining term on your mortgage of less than ten years. Over this period, the return on a stock market savings plan could turn out less than the interest rate you pay on your mortgage. So there’s a chance you’d be better off overpaying - though it’s still more likely that you’d come out ahead with the savings plan.
• If you plan to move home in the next ten years, this strategy exposes you to some risk. If you want to trade up, you’ll need to increase your mortgage or cash in your savings plan. And if the stock market is down and your savings plan has a low cash-in value you may have less equity than if you had overpaid your mortgage.
In these situations, I wouldn’t recommend you use the savings plan.
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Let time and compound interest make you rich
But for anyone else with a remaining mortgage term of over 15 years, I do recommend it. Especially now, because this is only the second time in all my 35 years in the financial markets when the cash-in value of a simple 15-year stock market savings plan is less than what you’d have got in a deposit account.
The recent performance of the stock market has been so dismal that it almost certainly means there will be big gains at some point in the next decade. And if your timescale is 15 years or more, you can afford to wait. In fact, you the longer share prices stay low, the more you should smile, since your monthly savings are simply accumulating more shares which will, some day in the future, be worth a whole lot more.
Taking the strategy one step further, you could ask: if the interest I earn on my mortgage repayment is only 4%, why should I make any capital repayments at all? You could have an interest-only mortgage and put more into the savings plan. In fact, this strategy - combining an interest-only mortgage with a stock market savings plan over a period of 25 years - is about the only fail-safe method I know for generating wealth.
Follow the methods I set out and use a fund supermarket to set up your savings plan and you can be en route to paying off your mortgage and having a big fat sum in your bank account as well.
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