Until recently, the decision on what to do with any surplus cash or savings was obvious. With mortgage interest rate historically low, investing this money into the great companies of the world via a low cost, globally diversified investment portfolio was the preferred option. I personally chose this option and continue to invest my own money in the same way as my clients.
But global central banks have been pulling their biggest lever to help battle inflation – increasing interest rates, thus increasing the cost of debt.
But now that interest rates are higher, if you are approaching the end of a fixed-rate deal and face a rise in mortgage costs, paying down some of the debt sounds more sensible.
So, should you overpay or use savings to clear your mortgage?
Investment Returns Outstrip Mortgage Rates in the Long Term
Over the long term, investing first is still likely to be more profitable in most cases – unless your mortgage rate is consistently higher than your investment returns and you redirect monthly mortgage payments to your investment account after the debt is cleared.
Investing broadly remains more profitable than paying off debt. With a 6 per cent average mortgage rate, overpaying a 20-year £200,000 mortgage by £200 a month would enable you to pay it off four years earlier and save about £33,600 in interest owed. But if you invest £200 a month into an individual savings account (ISA) for 16 years and achieve a 4 per cent net rate of return, you will make around £53,700 – or £20,100 more.
Investing vs Paying Off Debt
The Bank of England base rate might have peaked or be about to do so and, while interest rates will not go back to their 2021 levels for a while, it seems unlikely that they will remain this high for the next 16 years.
At the same time, while 2022 was a difficult year for returns and 2023 might not be much better, in the long term a 4 per cent average annual return makes for an achievable target. This does depend on your investment strategy.
If you invest the money in a pension rather than an ISA, the tax relief will give a further boost to your investments, and the difference between investing and paying off debt becomes even more pronounced.
What About Using Existing Savings to Clear My Mortgage?
You need to consider where the lump sum is coming from.
We have established that remaining invested is likely to be the better option financially. So, if you have an ISA for example and you’re seeing a temporary decline in your portfolio, you should perhaps avoid selling now, where possible.
Selling investments to pay off a mortgage also reduces your liquidity but also your ability to draw income from said investments.
But what if you have a sizable cash sum at your disposal? Utilising your respective ISA and pension allowances seems most sensible initially, and then consider paying down on the mortgage.
We’re Only Human
Let’s not forget the human reasons for paying off your mortgage.
Becoming debt-free can be a big relief. This can be helpful if you intend to retire early or reduce your hours, meaning that you have a lower or less regular income. So for some, the peace of mind and security can outweigh what any spreadsheet says.
So, this decision depends on your plans going forward and your overall attitude towards both investing and debt. This is a big decision and one that your financial planner can help with.