Being mortgage free is the dream of every homeowner, those who have achieve this dream now have a lot more disposable income to put towards anything they wish. For most this will be a question of allocating a regular over payment each month, however, some could do this as a lump sum; either as a result of investments or an inheritance.
Paying off your mortgage presents a few questions which you must consider carefully. Firstly, being mortgage free is just one financial goal which must be taken into consideration with any other goals you must have. Be mindful of any other debt that you may have, and the need to pay it off faster.
Secondly, paying off your mortgage for many is not just a question of financial strategy, but an emotional issue. Having a fully paid for house offers a lot of financial security, many would strive towards this.
Think about opportunity cost
Opportunity cost is something that is said a lot in personal finance, this is the cost of spending or investing money in one area as opposed to another. With regards to paying of your mortgage early opportunity cost is usually associated with investing in an index fund verses over payments.
Take our mortgage for example, the house was bought for £145,000 with a mortgage of £130,000 over 30 years at a current interest rate of 3.39%. Therefore, we are paying £578.02 every month, but if we over paid by £100 per month what would the result be?
With a regular over payment of £100 we would be mortgage free in 23 years and 2 months and save £19,628 in interest. Increase this to £200 per month overpayment, we would be mortgage free in 19 years and save a huge £31,175.
This sounds great, but now consider if you put that overpayment amount into a S&P 500 index fund. Between 1957 and 2018 the S&P 500 had an average annual return of 8%. So £100 per month into an S&P 500 index fund over 23 years at 8% you would have a pot worth £78,873, at £200 per month it would be worth £157,746!
If we invested our £100 over payment into an index fund and grew it to £78,873 at 23 years into our mortgage we would have £42,963 left. We could pay it off in full at that point and still have £35,910 left over. Compound interest is definantly on your side!
Do you have any other debt
While your mortgage will be usually your largest debt, it is also usually your cheapest. Therefore, you should really consider paying off any other debt first before you consider making any over payments. Your credit card at 20% will hurt you a lot more than your mortgage at 3%.
Just in the same why that you shouldn’t really start investing until you have paid off all debt, minus the mortgage, it is the same with overpayments. Unsecured debt such as credit card is always more risky to have and will have a lot of relief when it is gone. Plus once you have cleared that debt, any payments you were making can now go towards overpayments if that is what you want to do.
I am a firm believer of the debt snowball method, this is where you pay off the smallest debt first and move on to the next biggest, while paying the minimum on all other debt. This will give you quick wins and motivate you to carry on paying down debt. If you are tackling one debt at a time will focus you and achieve result quicker.
Consider the effect of inflation
Inflation effects everything from the cost of food at the shops to influencing central bank interest rates, and by extension the interest rate you pay on your mortgage. In the UK since the mid 1990s inflation has generally hovered around 1-3%. Since 2009 the Bank of England base rate has not exceeded 0.75% so mortgage interest rate have been at historic lows for over 10 years now.
Should we expect such low interest rates to continue? Well for the time being it would not be unreasonable to assume that interest rates will remain relatively low for some time into the future, therefore keeping your mortgage cheap. At the same time inflation is actually reducing the real value of your mortgage every year. For every £1 paid in good and services in 2010, the equivalent would cost you £1.31 in 2020.
In theory, between inflation reducing the real value of your mortgage, house prices increasing and interest rates staying at historic lows, it doesn’t make financial sense to overpay on the mortgage at this time. However, should inflation spike and interest rates increase proportionately, this could change.
Paying off the mortgage gives peace of mind
While the above may make it seem that overpaying the mortgage might not be the right thing to do, this is not always the case. Personal finance is a very personal thing and unique to each persons individual circumstances. Different people have different priorities and appetites to risk. While many are comfortable with the idea of investing in an index fund, many are not, therefore it could make sense to overpay the mortgage.
Another example where it would make sense to pay off the mortgage early is in the death of a partner. When you buy a house I would highly recommend taking out life insurance, then if you were to die your insurance could pay off the remainder of the mortgage balance. This will give the surviving partner peace of mind without the worry of paying the mortgage on their own, just make sure you are aware of any early repayment charges that could be applied.
There is no doubt that being mortgage free gives a lot of peace of mind and if you want to overpay and clear it quicker, then that is your personal choice. If it is right for you, then it is the right answer.
None of the content in this article should be considered financial advice, I am not a financial adviser and you should always do your own research prior to investing. These are my opinions only.