It may be easier said than done, but the process of improving your financial standing over time can really be summarised in two steps:
First, spend less than you earn. And second, put the excess earnings to good use.
The first step is a matter of budgeting, and your options are simple: cut costs or increase income. At step two, your options become diverse and complex, and your choices can lead to very different outcomes over the long term.
Paying off high-interest debts and building an emergency fund are among the highest priorities. After that, you might be considering investing your excess cash or using it to overpay your mortgage.
These can both be good options, but if you want to be sure you’re making the smartest choice in your circumstances, here are some points to consider.
Advantages of overpaying your mortgage
Most mortgage providers allow you to make overpayments up to 10 per cent of your remaining balance each year with no penalty. Overpaying your mortgage will:
- Help you to clear your mortgage faster
- Mean that you pay less in total
Here’s an example: Let’s say you have a £200,000 mortgage with a term of 30 years and an interest rate of 4.4 per cent, meaning your monthly repayments are just over £1,000.
If you overpaid by £200 per month, you’d clear your mortgage in only 21.5 years and save over £50,000 in interest by doing so.
If you have a mortgage renewal date approaching, overpayments could also reduce your loan-to-value (LTV), helping you to qualify for a more favourable rate with your next deal.
Disadvantages of overpaying your mortgage
One potential downside is the lack of flexibility and liquidity: having made an overpayment, it’s difficult or impossible to get that money back from your lender.
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Faced with a financial setback, you could be forced to take on debt at a higher rate than your mortgage, if you had insufficient savings.
Then there’s the opportunity cost: using the money to repay your mortgage means you’ll miss out on potentially more lucrative alternatives.
That’s where investing comes in.
Advantages of investing
Based on the past growth of the stock markets, investments in a diversified portfolio of equities are expected to achieve an average annual return of around 7 per cent (adjusted for inflation).
In any one year, your investments could return more or less than that – or even make a loss (the global markets record a loss in around 27 per cent of one-year periods). But, over many years, you would typically see returns at a rate higher than your mortgage repayments are made at.
How much better off could you be? Let’s say you have the same mortgage as our previous example, but instead of overpaying, you invested that extra £200 a month.
After 21.5 years, you’d have around £85,000 left to pay on your mortgage. But if you achieved a consistent 7 per cent annual return, your investments could be worth around £113,000. So, you’d be able to clear your mortgage (though there may be an early repayment charge to do so) and have around £28,000 left over.
Alternatively, you could continue making your regular mortgage repayments and investing £200 a month. By the end of your mortgage term, your investments could be worth £230,000.
Disadvantages of investing
If it’s not immediately clear, the biggest drawback of this approach is the risk involved. There’s no guarantee that your investments will grow by the assumed rate, and no easy way to accurately predict the actual rate.
Plus, sudden drops in value are commonplace in the stock markets, and bad timing could affect your ability to repay your mortgage (or a portion of it) at an intended date.
You should be confident that you’d be able to continue to repay your mortgage at your current schedule for longer, if this were the case.
If you don’t invest in an ISA you may have to pay tax on any gains, while if you opt for a pension rather than investment account, you won’t have access to it until around retirement age.
Choosing an approach
This isn’t a decision to make based on hypothetical calculations alone. You should consider the following factors:
- Time. The more time you have, the greater the likelihood that investing will produce the desired results. It’s not suitable as a short-term strategy
- Attitude to risk. Interest savings made by overpaying your mortgage are certain. Investment returns, while potentially higher, are not guaranteed
- Lender terms. Overpayments should only be made regularly if they’re penalty-free, so check your mortgage agreement before making any
- Tax position. Tax on your investment gains could significantly diminish your returns, so if you have no ISA allowance, this might impact your decision
- Preference for liquidity. Money put into investments can be extracted far more easily than money repaid to a lender
- Preference for security. There may be an emotional benefit to seeing your mortgage shrink that you value more than money
Make sure you always consider your personal circumstances and expected future needs, and consider speaking to an advisor if you can.
When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results.
