Paying off your mortgage early will destroy your finances.
If you were raised in an average family you were likely taught the importance of paying down your mortgage as quickly as possible.
Your parents probably believed it was the wisest financial advice they could give you.
That advice was coming from an era of high interest rates, inaccessibility to investing markets and lack of available information. Today’s world is a very different place, in which it is potentially financial suicide to sign-up to a repayment-heavy 15-year mortgage term.
Today we’re laying out the arguments against paying down your mortgage early, the risks involved, and our alternative approach to paying off your house and getting financially free in the process.
Nothing here is financial advice and is certainly not for the faint-hearted or the financially illiterate! This is what we’re doing.
The Myth Around Shorter Mortgages
Maths teachers up and down the land will tell you that shorter mortgages make the most financial sense.
A mortgage is a loan, they’ll tell you, and loans attract interest so long as you hold them. If you hold the loan for fewer years, you will pay less interest overall. Case. Closed.
This is why they are still maths teachers; instead of retired, with their feet up, eyeing their investment portfolios.
An investor worth their salt would give you a very different lesson.
No Risk, No Reward
Investors measure risk against return. They don’t invest for a low return when the risk is high.
And it turns out having a shorter mortgage or paying more than the minimum is one of the riskiest things you can do for your finances.
One reason for this is that when you make a mortgage payment, that money gets locked away. It’s gone from your accessible funds.
Extend this concept into mortgage overpayments, and you find that a lot more of your money gets locked away beyond your reach.
The Reward that you get from making a mortgage overpayment is that you get to save around 2% interest.
The Risk is that when hard times strike, as they do for all of us at some point, your money is trapped in mortgage jail and there is nothing you can do about it.
Repossession Risk Is Higher For Overpayers
Let’s start at the extremes before looking at the more every-day ways in which overpaying can kill your finances. Overpaying now actually raises your risk of repossession in a downturn.
If you do the so-called “right thing” and overpay your mortgage – filling your house with equity and your pockets with air – then if the day comes that you lose your job and can’t make the payments anymore you are in a far worse position with the bank.
How many people will have lost their jobs due to Covid and are now wishing they hadn’t made over payments on their mortgage?
For one thing, you have no spare cash to use in emergencies. The fact that you’ve overpaid your mortgage previously counts for exactly nothing in your favour.
And in the eyes of the bank, your house is a very attractive target for repossession.
Say the bank owns 50% of the house because you’ve been diligent and overpaid, resulting in 50% of your mortgage being paid off.
This means the bank only needs to sell the house for 50% of its initial purchase price to recoup their money. They get paid first, see, and you’d get nothing back.
All your hard-saved equity would have gone up in smoke. In a recession when the market isn’t moving, they might be happy to sell at half the initial purchase price for a quick sale.
If you find yourself in a recession, unemployed, and with house prices falling like they were during 2009, then the banks will be looking at houses owned by unemployed people (i.e. high risk), and which are also full of equity, because then even in a falling property market the bank can get their money back on these houses through repossession.
Remember, the banks are keen to give money to those who don’t need it; and the first to screw you when you’re in desperate need of some.
Contrast with someone who still owes 90% on their mortgage and so only has 10% in equity, whose house falls by 30% in a recession, to 70% of its initial purchase price.
The bank is less likely to want to repossess and sell this house because they know they’ll lose out.
If they’re trying to scrape together some emergency profits mid-recession, they’ll start with the low hanging fruit.
An Investor’s Approach To Mortgages
We hate the idea of locking our money away in the bank’s pocket for years, outside of our control. Much better to keep as much money as possible back from the bank, in our own pocket. It’s partially a matter of control – that money is better off protecting us from recessions, than protecting our banks.
It’s also a matter of return. We believe we can put that money to work for a better return than the interest saving we’d get by paying down the mortgage early.
Let’s look at what happens over a 15-year period of diligently paying down a £200,000 mortgage.
The interest on a modern-day mortgage is typically around 2%, which is less than the rate of inflation, typical around 3%, so by making overpayments you are losing money in real terms.
By this we mean inflation is eating away at your money’s future buying power at a rate of around 3% a year, while your mortgage interest saving from overpayments is around 2% per year, so a real loss of 1%.
Avoiding interest on your mortgage through overpayments is really just like paying into an elaborate savings account, which pays you around 2% interest.
Keeping the maths simple, by “doing the right thing”, in 15 year’s time you’d be down by £16,000 at real time value of money.
This is what normal middle-class people do, and it’s one amongst many common lost opportunities for financial improvement which keeps them trapped in a job all of their lives.
If you play the game with your finances, you can retire early, you could pay off your mortgage in one go at that point as well, and have your feet up watching the world pass by, by the time you’re 40.
Being smart with your mortgage payments opens up a big opportunity for you to build an investment portfolio of stocks and shares and other investments, which pay you a big passive income for the rest of your life.
‘Investors’ is how we would describe ourselves, if people asked us what it is we do. One way to think of investing is just “moving money around”.
Instead of moving your money from your current account to your mortgage account, instead move as much of it as you can to a stocks and shares ISA, whilst only making the minimum repayments on your mortgage.
It takes the same amount of effort, except one could cripple you financially, and one can set you financially free.
It makes a big difference over that same 15-year period. An 8% stock market return, minus 3% inflation, gives us a 5% real return on average each year.
At the end of the 15 years, you would have not paid off the mortgage, but you could have £280,000 in your ISA. You can then either pay off the mortgage by writing a single cheque, and pocket the £80,000 difference… or carry on growing your freedom fund at 5% a year, knowing that you could pay off your mortgage at any time.
In reality, you do need to pay something towards your mortgage capital every month unless you are on an interest-only deal, but we’ll show you soon how you can get that money back.
People who pay down their mortgages early tend not to be interested in investing, because they see it as either too risky or too complicated. Let’s quickly address both of these points.
#1 – Too Risky
We’ve shown that by overpaying you are guaranteed to lose money.
And we’ve said that long term investing can make around 5% real annual returns on average – but how can we know that?
First, historical precedent. While stock markets often do go down, like in March 2020, the upwards-periods have always more than compensated for that.
The average annual return on America’s main index the S&P500 is 10% since the index opened nearly a century ago in 1926.
And second, logic. Stocks are productive companies employing people and capital to make profits. Businesses do not go to the trouble of existing, just to make measly profits of 2% – which is what you can save on a mortgage.
#2 – Too Complicated
Investing can be just as easy as making a mortgage overpayment. Open your stocks and shares ISA with a robo investing platform like Nutmeg, Moneyfarm or Wealthify, and all you need to do is set up a monthly direct debit and let them take care of the rest.
You will answer a few questions on sign-up about how you want your money to be invested – really simple stuff that anyone can answer – and they will build you a personalized, globally diversified portfolio and manage it for you.
Open an account with Nutmeg via the link on the Offers page, and the management fee will be reduced to 0% for the first 6 months – it’s an easy win. We have new customer offers for all 3 of these robo-investors in the Robo Investor section on there.
What If Interest Rates Rise?
People are funny about mortgages. They think they are magic in some way and that they must be treated with reverence, but they are just a very low interest loan over an incredibly long-term.
People seem to panic about not paying down their mortgages in case interest rates rise in the future. So what if interest rates do rise?
We are not advocating spending your would-be-overpayments on frivolous things. We’re saying it’s better to put that money aside to go to work for you in investments.
As long as your mortgage allows unlimited overpayments – and you can switch provider if not – then if interest rates did rise to say, 10% in the future, you could instantly move your money around from the ISA, into the mortgage. Job done.
The risk is that your investments may lose value if interest rates suddenly rose significantly.
But interest would not rise suddenly – it would happen gradually over many years, and you’d be able to see it climbing long before it approached the 8% average return available on the stock market.
Extreme Money Moving – What We’ve Been Doing
With mortgages, we personally are willing to go further than most people – we actively avoid having money in our houses.
Andy (MU co-founder) is on a special tracker mortgage meaning he can restructure his deal to withdraw equity at any time.
Ben (MU co-founder) has a 35-year mortgage, which is the longest term he could get, meaning his capital repayments are as small as they can be. But as well as this, he has now 3 times withdrawn equity from his house.
You can do this when you change mortgage provider, which you can usually do without penalty if you are outside of a fixed term.
Many people are on fixed term mortgages of 2, 5 or 10 years, with a variable rate thereafter, even if the total term is for 15, 30, 35 years or so on.
The first time, he took out around £30,000 to invest in another rental property.
The second time he withdrew around £20,000 to help transform another rental property into a HMO multi-let in order to double the rental profits.
And the third time was this year, when he took the opportunity to withdraw £8,000, and invested it in the stock markets during the corona crash of Spring 2020.
This would be considered high risk by most people, but Ben has been able to use that money to increase his monthly passive income forever.
And with a higher income, you can then buy more assets to increase your passive income further.
What could have been sat in a house losing value can instead be put to work to build a future income stream of potentially thousands of pounds a month.
Whether you stop overpaying your mortgage, extend your mortgage term, or even contrive to get some money back out of your house, just by moving money around you can be far more financially secure.
Are you overpaying your mortgage? How do you balance that with investing? Let us know in the comments below!