Should you clear your Mortgage or Invest?
One of the most common questions I answer for my clients is whether they should pay their mortgage off or invest. It’s an area of financial planning that can be rife with biases. Its a deep question with a lot of factors to consider and can sometimes be a case of head vs heart, maths vs emotions.
I would suggest there isn’t so much as a right or a wrong, but there certainly could be an optimal and a sub-optimal.
Is Debt bad?
As is often the problem with conventional wisdom, its followed almost blindly and without question.
We’ve grown up being told that ‘debt is bad’ and heard our elders proudly proclaim, ‘I don’t owe anybody anything, it's all bought and paid for’.
Its maxims like this that cause many people to focus on getting the mortgage cleared as quickly as possible, despite not having given deep thought as to whether it’s the best move. The fact is, borrowing is a very useful tool and there is absolutely such a thing as ‘good debt’. Being able to leverage your wealth with borrowing can really help speed up your long-term Wealth Building.
Considering that interest rates are at historic lows, and we’ve seen high market returns since 2009, it really could be the right choice to keep that cheap debt and deploy your assets in other ways.
So, what’s the answer? A rational look at the facts as they pertain to you could have a significant financial impact.
Is this a foreign concept?
If the idea of not paying your mortgage off as soon as humanly possible is a totally foreign concept to you, let me briefly outline why you might consider it.
As mentioned, interest rates are at historic lows, and we know the long-term growth of the capital markets is around 10% per year. If your mortgage rate is 3%, you could, in theory, invest and either have the growth pay off a significant amount of the loan for you, or just end up with a greater amount of net wealth.
The Maths
For example, a $200,000 repayment mortgage, at 3.5% over 30 years, would cost you in total $323,440.
If every month you overpaid that mortgage by $500, you’d clear the loan in 15 years and 6 months and would save in interest $64,173.
Sounds wonderful!
However, if you invested that same $500 every month into an S&P 500 tracker, which has averaged 10% per year since 1926, but let’s be cautious and take an average of 8%, you’d have a total of $179,622 over the 15 years 6 months, which is growth of $86,622 — so around $20,000 better off.
Also, your mortgage at this point would be about $125,000, yet you’d have $179,622 in invested assets, which is more than double your interest savings. You could clear the loan if you wanted to, and have $54,622 left over, or perhaps find some other opportunities with that money.
The difference is even more pronounced with a lump sum.
On the same mortgage, if you paid $100,000 in the 5th year (as an example) your loan would be cleared after 13 years 6 months and you’d save $77,993 in interest.
If you invested that $100k and it grew at 8% per year over 13 years 6 months, it would be worth $282,631. With that level of growth, you’d be better off by $104,638.
The other factor is Inflation. If this was at 3% per year, the relative value of your mortgage at the 13 years 6-month mark wouldn’t be $125,000 anymore, it would be $81,604. You’ve let inflation do some of the work for you. The longer you stave off paying the mortgage, the greater this effect.
Seems like a no-brainer!
So why clear your mortgage?
The example above is fairly typical and could be a compelling reason to invest rather than pay down your loan. But this isn’t the whole picture. There are some really good reasons to clear your debt.
1. Security & Peace of mind.
No matter what, you own your property. You don’t have the burden or hassle of a mortgage to manage and the property feels truly yours. Your home would truly be your castle… even if it is a 3-bed semi in Bognor.
Having debt, for some people, can have an emotional weight and you may just want to be free of it as soon as you can.
Your mortgage debt is ‘guaranteed’, in that you’re 100% certain you’re going to pay it or save it if you pay your mortgage off early. However, if you go the investing route your success or failure is dependent on your returns, which is subject to the market and your behaviors as an investor.
You need to be certain you’re managing those investments, and your ongoing investment management choices, as effectively as possible to ensure you get sufficient returns.
Lastly, having no mortgage on your home and/or your properties puts you in a very secure position. Regardless of what the stock market does or if you have a period of time with no income, this security remains.
This peace of mind could be valuable not only in and of itself but in so much as it frees you up to take greater risks in other areas.
Maybe you’ll take the plunge on that new business idea, or maybe you’ll increase your equity exposure.
2. Saving time, costs, and interest.
Having a mortgage can cause practical issues. You periodically may have to remortgage to get the best rate, which can involve time, fees, and hassle, and worst of all, talking to the bank!
Having borrowing may slow things down if you ever want to sell/buy.
And of course, the big one, you save money on mortgage interest. Heaven forbid, interest rates could even go up one day and you’d be laughing all the way to the bank.
3. Building net income and equity.
For landlords, you get to keep more of your rental income as there’s no mortgage costs. This is great if you’re looking to build up an income from properties (but don’t make the mistake of thinking property rental income is ‘passive’!).
If your property is in the UK, having no mortgage costs is particularly relevant as you can no longer deduct mortgage interest against tax, meaning you could receive zero net income after mortgage costs, but still pay income tax on the full rental income. Ouch!
Right, where are we? Confused? Conflicted? Full of a general sense of ‘let's put this on the too-hard pile’?
You’d be forgiven, so far, we have strong arguments on both sides. So, what do you do with that? Heres some additional factors to consider;
- Period of time until Retirement / Financial independence — if you’re getting close, perhaps this could tip the scale in favor of clearing debt.
- The ‘sleep ability test’ — Does the idea of debt niggle at you? Does the idea of exposing your mortgage over payment money to the vagaries of the stock market keep you up at night? If so, pay off the mortgage, this is equally as relevant as the maths.
- What is your goal and where are you in relation to it? Are you planning to build a portfolio of properties for income? In which case, you may need to stay liquid to help purchase other properties — keep the debt. Are you at the point where you have as many properties as you need and are now looking to take income? — Clear the debt.
- Is this your home or a rental property? You may wish to have the security of your home being debt free but less concerned about debt on any additional properties.
- What is your attitude to investment risk and investing philosophy? Are you confident you can invest correctly and ensure you exhibit the correct investing behaviors to maximize returns? Or, have you got a great advisor who can do this for you? If not, definitely clear the debt!
- Do you have a UK Inheritance tax issue? If so, this can be made worse by clearing debt as it can make it harder to employ strategies like Gifting to reduce your estate as property is less liquid then investment assets.
- Are you planning to use debt as a tax-free income by leveraging off your properties as they grow in value? This is a strategy employed by professional property investors and is full of pitfalls but, done correctly and in the right circumstance, is very effective.
- Are you fairly certain you wont come to a definite decision as to what you’d prefer? Take the balanced two-prong approach; do a bit of both!
Lots to consider, and I’m sure there’s some other factors specific to you which I haven’t covered.
If you’re interested in answering this question for yourself, I’d suggest you start with the maths. Then, be honest with yourself about which approach seems most appealing, that you’d be most comfortable with and that you could actually achieve. Part of answering this will take a clear understanding of your circumstances and goals and your plans to reach them.
Here are some calculators to help you;
Mortgage Overpayment Calculator — Here
Compound Growth Calculator — Here (for comparison, the amount of years should be the same as the shortened term of the mortgage following the overpayment in the overpayment calculator)
Regular savings Calculator — Here (same as above but for regular overpayment rather than a lump sum)
When I help to answer this for clients, not only do we discuss all this in depth, but we use CashFlow planning Software to run different scenarios and project the best outcomes.
This is a profoundly powerful tool you can read more about here.
In the end, do what you feel is right for you, gives you the most peace of mind and helps you most towards your goals.
As ever, if you need help and support in making these decisions, don’t hesitate to reach out and I will do my best to remove any uncertainty, give you a clear path and ensure you don’t make any financial mistakes!
By Adam Deane
