Pay off the mortgage - or do something else with the cash?
Blog reader M Pawson asked about the pros and cons of paying off paying off a mortgage early – see ‘Reasons for repossessions’, below.
M Pawson is in the enviable position of being able to clear his mortgage, but doesn’t know whether it makes sense to.
We’re always getting questions about this – increasingly from borrowers who are thinking of interest-only mortgages, where they don’t make any repayments at all, but try to do something better with the cash elsewhere.
It’s all about expectations of returns. Oh yes - and risk....
Take a £200,000 mortgage and for simplicity’s sake say the rate, for the duration of the 25 year term, is 4.5 per cent.
Borrower Jill goes the repayment route and her bills are £1,112 per month. The total cost of Jill’s credit, on a repayment basis over 25 years, works out at £133,499. So to own the home outright, including the capital repayment, Jill hands over £333,499.
Borrower Simon goes for interest only. Simon’s monthly bills, just serving the 4.5 per cent interest, will be £750. If Simon pays that every month for 25 years he’ll have parted with a total £225,000 – and yet he still won’t have paid back a jot of the capital borrowed.
But Simon is paying £362 less per month than Jill. Say he shoves that extra cash into a tax-efficient savings scheme, such as a unit or investment trust held inside an Isa (so no capital gains tax).
In theory – excluding tax and costs etc – if his £362 per month compounds up at the same rate as the mortgage, Simon will roughly end up in the same position as Jill in 25 years’ time. He’ll have £200,000 to clear the debt. Try This is Money's calculators.
But if he is investing in equities, he could reasonably hope to get more than the rate he was paying on his mortgage, over time. Say his savings compound up at a modest five per cent per year: then, his £362 per month would grow to a total £217,693.
That would pay off his house entirely and leave him an extra £17,000-odd. If the equities compounded up at an average six per cent, he’d get an extra £53,000, and at seven per cent, he’d get an extra £94,000…
All that sounds ominously like the sales patter used by companies flogging endowments as mortgage repayment vehicles back in the eighties and nineties. No reminders needed about what happened there.
And that’s the risk. M Pawson’s no-risk strategy would be to pay the mortgage off right now. Or he decides to try and do something more clever with the cash – and risks getting it wrong.
- Richard Dyson
What I don't understand is why current account mortgages don't get more column inches.
People get fixations about the interest rate that they pay on their mortgages but lose sight of the fact that with a CAM, the aim is to reduce the sum outstanding and you only pay interest on that figure.
Take a situation where you take out a mortgage for the £200k. Day 1 you transfer in £5000 from your savings (which are only earning you 4.5% taxable if you are lucky). Straight away you only pay interest on the balance. This also means that whilst you are not making 4.5% on your savings, you are saving at a greater rate and its tax free.
CAMs are eminently suitabe for people who have money left over at the end of each month, have savings, and who don't want to end up paying huge interest amounts over the life of a mortgage. Perhaps they don't bung brokers as much commission as "conventional" mortgages - but of course that would be me being cynical wouldn't it?
Posted by: Ricardo | November 13, 2005 at 06:03 PM
Do you have any suggestions on where to get these returns. I've been reading a lot recently about eastern european and russian funds?
Dave
Posted by: D Jacobs | November 03, 2005 at 05:20 PM