Lots of people dream of paying off their mortgage early. Others want to stick every spare penny they have available in the stock market. Not to mention the saving brigade.
But which option makes most sense?
In this article we’ll look at:
- How current mortgage rates compare to historic mortgage rates;
- What returns we might expect;
- What you need to consider when deciding whether to save or pay off mortgage or invest;
- The advantages and disadvantages of each; and
- What wins the save or pay off mortgage or invest debate.
Mortgage rates
For most people, most of the time, it all begins with mortgage rates.
The table below shows UK two year fixed rate mortgage rates. It is based on Bank of England data for 75% loan to value mortgages.
You pay a 25% deposit and the bank gives you a mortgage for the remaining 75%. (Other loan to value amounts aren’t always available, so the data isn’t as comprehensive.)
Based on the data, mortgage rates have just started creeping up but they remain at about 1.7%. This is up from a low of 1.3%.
Make no mistake, these rates are really low. This is great from the point of view of borrowing money, but not so great from the point of view of saving money.
I say that, because paying off your mortgage is pretty much like saving and getting paid interest or investing.
You get an investment return equivalent to your mortgage rate when you pay off your mortgage. Paying off a £50,000 mortgage with a 1.7% interest rate is just like investing £50,000 and getting a 1.7% return or saving and getting paid 1.7% interest from the bank.
Because of this we can compare mortgage rates to savings rates and market returns to see which is a better option.
To make a proper comparison in the save or pay off mortgage or invest debate, you need to consider three factors:
- Expected returns or savings rates;
- Costs;
- Risk appetite.
Expected Returns
According to Money Saving Expert, typical savings rates right now range from 1.5% for easy access to 2.6% for fixed rate savings.
Those rates are low, so it is worth considering what kind of returns can be achieved by investing in the stock and bond markets.
Historically, stocks have returned over 10%. That said, times have changed. Vanguard’s Economic and Market Outlook for 2019 suggest 5% max for the next decade.
That is a maximum and it assumes you are 100% invested in stocks. Most people will have some bonds in their portfolios to help get them through the bad times.
Vanguard provide hypothetical nominal returns for a range of portfolios for the coming decade. The median projected return for a traditional 60/40 split between stocks and bonds is 3.6%.
I’m sure many investors don’t expect such a low return from their investments, but 3.6% still beats the 1.7% you’d get from paying your mortgage off or the 2.6% you’d get with a fixed rate savings account.
However that is before costs and risk are taken into consideration. These are two characteristics that define investing in financial markets.
Costs
Whereas saving or paying off your mortgage don’t usually cost anything, there are plenty of costs associated with investing in stocks and bonds. If you do it yourself with cheap index funds you should be able to keep your fees below 0.5%.
Taking 0.5% away from Vanguard’s 3.6% projection for a 60/40 stock and bond split leaves you with 3.1%.
However, investors in actively managed investment funds may pay a lot more than 0.5%.
The Money Advice Service suggests annual fees of up to 1.8% for active funds, and that’s before commissions, taxes and portfolio turnover fees are taken into account.
You do the calcs! If you ignore all the other costs and just subtract 1.8% from 3.6% you are left with just 1.8%. Less than you get with a fixed rate savings account and only slightly above what you’d get for paying off your mortgage.
The chance of being 0.1% better off through investing but with a whole lot more risk shouldn’t get too many people over excited!
You’d be better off paying off your mortgage, than investing in an expensive actively managed fund. Unless, you can find a fund that will provide you with better returns that is.
The thing is, there has to be a reason why so many people pay high fees to have professionals manage their money, and there is:
There are funds like Lindsell Train and Fundsmith that have been providing double digit returns recently. The investors in these funds would think it is crazy to talk about savings accounts and paying off mortgages.
They have been coining it in over the last five years. The only problem is, past performance is not a reliable indicator of what the future holds.
Investing in an actively managed investment fund brings its own risks. You should do your due diligence if that is something you are considering. You might pick one that provides you with superior returns, but at the same time, you might not.
You can read more about actively managed investment funds here.
Risk Appetite
Some investors will be thinking as long as stocks have a bigger return then just go with stocks! But sensible investors really need to consider risk. In fact sensible investors need to way up whether the potential returns from investing are worth the risk at all.
Stock markets have been known to crash from time to time and not recover for a long time afterwards.
At the time of writing Japanese and Chinese investors may have wished they’d paid off their mortgages or simply opened a savings account rather than investing in their own stock markets. They are both down considerably from their peaks many years ago.
Stocks are a risky asset. Investors need to be compensated for taking on this risk through higher returns. If investors didn’t get compensated for the risk, they wouldn’t invest. Why bother when they can invest in a riskless asset.
When people talk about riskless assets they are usually referring to treasury bills, cash or short term government bonds. In each case you are pretty much guaranteed to get your money back and whatever return you were promised.
Paying off your mortgage early or sticking your money in a savings account are pretty much risk free too. By comparison, investing in stocks is risky. Moreover, investing in stocks needs to provide you with greater returns than paying off your mortgage, otherwise you shouldn’t do it.
Risk vs reward
The question then becomes, how much greater do the returns from stocks need to be to compensate you for the risk.
History suggests quite a lot. Since 1900, global equities (stocks) have beaten cash (Treasury bills) by 4.3%.
So, in the past investors have demanded about 4.3% to compensate them for the risk of investing in stocks. Put another way, today’s returns for stocks simply wouldn’t have cut the mustard. Certainly not the lowly figures
Vanguard are projecting anyway.
In defense of today’s poor stock projections, we are living in a low interest, low return environment. In a world where 5% is the new 10%, perhaps an extra 1% might be worth the risk to some investors.
For those that do think the risk is worth it, there are some other things worth thinking about before you rush off and stick all your money in the stock market.
Things to think about before investing
You might want to limit your tax burden for example. If you do, paying off your mortgage might make most sense because it is a tax free investment.
And so far, we have only really talked the financial side of things. There is the psychological benefit of being mortgage free. For some people, debt is a burden they would happily live without. Even if you don’t mind debt, not having mortgage payments to pay may make life more convenient for you.
Paying off your mortgage or saving also have the advantage of simplicity. You don’t have to mess around finding a broker, deciding on asset allocation, or deciding what specific funds to invest in. You just pay more money to your mortgage provider or add money to a savings account.
On the flipside, investing in stocks and bonds also have advantages. The first is diversification.
If we ignore savings for a moment and just consider property as an investment asset, then a house is one asset in one town, in one country.
On the other hand, investing in a global fund of stocks could give you thousands of small pieces of businesses dotted throughout the world. If something goes wrong in your country or town, the price of your house may go down. Just like stock markets, housing markets crash from time to time.
The second advantage to investing rather than paying off your mortgage or having a fixed rate savings account is liquidity. Stocks and bonds can be sold pretty quickly if you need the money in an emergency. Houses certainly can’t and most fixed rate savings account won’t let you take your money out early without some kind of financial punishment!
At the end of the day, stock market returns, savings rates and mortgage rates are all really low right now. In the mid 90s mortgage rates were over 8% and savings rates hit double digits. Stocks often hit double digits, and historic returns for stocks in the UK are 10%.
If predicted stock market returns go up compared to mortgage rates and savings rates, then investing may make sense.
However, if mortgage rates go up compared to stock market returns or savings rates paying off your mortgage early will probably make more sense.
And of course at other times savings may be the way to go.
Here’s a quick summary of the advantages and disadvantages of each:
Key advantages to overpaying your mortgage are:
- Tax – It is a tax free investment;
- Psychological – It can be gigantic weight off your mind to be debt free;
- Risk – It is risk free;
- Simplicity – You don’t have to mess around with stocks and bonds; and
- Convenience – You won’t have mortgage payments to make.
Key advantages of using the money to invest are:
- Diversification – Houses and cash are single investment assets. Investing in a global fund of stocks could give you thousands of small pieces of businesses throughout the world;
- Increased returns – Usually investing in the stock market will provide the highest investment returns;
- Liquidity – Stocks and bonds can be sold pretty quickly if you need the money in an emergency, houses can’t, and getting your cash out of a fixed rate savings account can be tricky.
Key advantages of saving are:
- Increased returns when compared to paying off your mortgage;
- Less risk and simpler than investing in the stock market.
The bottom line
For most people, it comes down to risk against reward. Sometimes, when the predicted returns for stocks are much higher than those on offer from savings accounts or paying off a mortgage, many people should be willing to take on the extra risk associated with stock markets.
At other times it probably makes sense to go with a savings account or paying off your mortgage. Going with the one that provides the highest returns.
That said, there are always going to be people out there where the psychological benefit of being debt free trumps all. For these guys paying off a mortgage no matter what additional returns are on offer elsewhere is likely to be the most sensible decision.