Should you overpay your mortgage or invest?

Investors, who are also homeowners with a mortgage face an ongoing choice through their financial lives – pay down the mortgage or invest excess cash instead?

It’s a simple question, but the answer really depends on personal circumstances: Age and job status, the terms of the loan and the interest rate, and, very importantly, whether you are a risk taker or more risk averse.

Safety first or the power of compounding?

One thing is for sure, you’ll save thousands of pounds in interest by paying your debt down sooner. Mortgage payments are made up of two components; interest on the loan and a ‘principal’ amount, which goes towards paying down the outstanding balance. The longer you have the mortgage and the higher the interest rate, the more you pay in interest. This is especially true in the early years when the loan balance is larger, and you are proportionally paying a lot more on the interest than the capital.

Yet overpaying your mortgage i.e. paying more than you need to under the terms of the loan agreement, comes with an ‘opportunity cost’. In other words, had you invested the money could you have achieved a return in excess of the interest on the debt? Building wealth over decades by allocating capital to well-managed and growing companies has, historically at least, been a reliable way to grow wealth. However, to fully harness the power of the stock market and enjoy the benefit of compounded returns, you need to leave your money invested for a long time. An absolute minimum of five years but ideally decades.

At higher mortgage interest rates there is arguably less of an opportunity cost. It is one thing bettering a 2% or 3% rate with investment returns, but achieving upwards of 6% consistently is much more difficult. The higher the interest rate is the more it makes sense to repay debt as quickly as possible. That’s why high-interest debts such as credit cards or personal loans should be repaid as a priority.

Rising interest rates

The current environment of higher interest rates is a worry for many mortgage holders, but much depends on the trajectory of interest rates in the future, not just the next year or so. If inflation and interest rates stay high over the medium to longer term, then reducing debt is likely to be wise. However, it is also possible rates could come down quite sharply and reduce the cost of mortgage debt.

The good news is that inflationary pressures appear to be easing and central banks look set to start cutting interest rates this year, though they are unlikely to return to the very low levels that we experienced between 2010 and 2020.

In the meantime, some households could even enjoy a higher return on cash, which as opposed to investing is risk free, than the prevailing rate on their mortgage, for instance if they secured a fixed rate close to the lows a few years ago. In these circumstances it can make sense to accumulate as much interest as possible and use that to help pay down the debt at the point of remortgaging. However, don’t forget that tax on interest over a certain level, known as the personal savings allowance, is taxable and this effectively reduces your return. .

If you do decide to pay down or pay off a mortgage you must consider any penalties for doing so. Early repayment charges (ERCs) often apply during any fixed or discounted period and are usually calculated as a percentage of the amount you repay. Often, these are tiered and fall away over time. Depending on the circumstances, it can be worth paying an ERC as the interest saving could be more than the fee incurred.

Pension boost

One factor that might tilt the balance in favour of investing instead of overpaying your mortgage is if you can get a significant leg up on the money you put in. In this regard, using a pension scheme really stands out.

Pension contributions benefit from tax relief which can ‘supercharge’ your returns. Basic rate tax relief, for instance, adds 25% to the value of your pot, and for higher rate taxpayers there is an even larger boost. If you have access to a workplace pension, your employer will pay in too, making it a really cost-effective method to save for retirement. This should be maximised to the greatest extent possible before investing elsewhere.

Some investors use this strategy to help pay off their mortgage, but you need to bear in mind that money in a pension can’t be accessed until a minimum age is reached. That’s 55 at present for personal pension schemes, but it is set to rise. Bear in mind too that pension rules, and tax relief, can change in the future. The longer you have to invest the more beneficial the investing route might be, especially when it comes to pensions.

To overpay mortgage or invest? It’s not just about the maths…

The answer to this quandary doesn’t necessarily lie in a spreadsheet. Although investing may generate higher returns than a loan's interest cost, markets also come with the risk of losses. That uncertainty is a factor in itself. The peace of mind of lowering mortgage expenses and not having to worry about the performance of financial markets may outweigh the potential advantages of investing. It comes down to priorities and, quite possibly, how different routes make you feel.

Although many people would consider it an inferior route from a mathematical perspective, prioritising a smaller mortgage over investing can make your financial position more resilient. It may give you greater control and more options, and it could reduce anxiety about an uncertain future. Plus, when you overpay your mortgage, the debt will shrink and you will have more disposable income, which could fund contributions into pensions or other investments. However, if you are happy taking risks, the power of compounding investment returns over long periods and investing as much extra money as possible can be a hugely powerful force. This is provided your investment strategy is sound, and you have a long enough runway ahead to deal with the inevitable volatility markets throw at you.

Whether it’s better to overpay your mortgage or invest also hinges on how your broader finances are looking. The bedrock of strong financial health is when you don’t have other high-interest debts to pay off and you have built up a fund for emergencies of around six months’ expenditure.

Financial Health Check