Fool's Eye View

[ May 24, 2000 ]

Mortgages, Investments and Tax

By Nigel Roberts (TMFNigel)

Chippenham, Wiltshire -- Many people are coming into inheritances, big and small, but what should you do if your Great Aunt leaves you £10,000? Well if you read step 2 of our Ten Steps to Investing Foolishly, you will soon conclude that thanks to the miracle of compound interest you'd be best off inveting this money in the stock market. Wait 20, 30 or 40 years and then live off the proceeds into your old age. Very Foolish!

But if you are a taxpayer, and also a homeowner with a mortgage to pay, what would your decision be? If you were to say that you would still invest it in the stock market, would you still be making the most sensible decision? Let me show you, with some examples, what this Fool would do.

Three Choices

Essentially, as I see it, you have three choices. You can put the money into a savings account; and Egg are currently paying 6.3% before tax. You could pay off part of your mortgage; the Principality Building Society standard variable rate is 7.49%. Or you could invest it in the stock market, and expect that over a long period of time you would make about 12% per annum (the historical return since 1918).

Clearly faced with this choice, investing at 12% is much more attractive than investing at 6.3%, and so if you are a Fool, and ignoring the comparative risks at the moment, you would sensibly choose to invest the money into the stock market. Imagine 12% compounded for 25 years...

But what if you are a 40% taxpayer? Would this still be the best choice? For simplicity in our calculations, let's assume that in one year of investing your £10,000 you do make the returns shown above, and you pay tax on the interest and the gains that you have made.

                    Savings    Mortgage   Invest
% return               6.3%      7.49%       12%
"Profit"              £630       £749      £1200
Tax on profit at 40%  £252         £0       £480
Real "profit"         £378       £749       £720

It is pretty clear, if you expect that investing in the stock market will give you a return of 12% a year over the long term, and you are a higher rate tax payer, the best thing that you can do is to pay off your mortgage as fast as you can. Any money invested in paying off your mortgage is effectively earning interest tax-free. If you are paying 7.49% interest on your mortgage you will need to be able to earn 12.48% before tax simply to keep up with the rate that you would get if you paid off your mortgage first.

The situation is slightly different for a basic rate taxpayer.

                    Savings    Mortgage   Invest
% return              6.3%       7.49%       12%
"Profit"              £630       £749      £1200
Tax on profit at 22%  £139         £0       £264
Real "profit"         £491       £749       £936

Here you would, theoretically, be better off investing the lump sum into the stock market; but this ignores all the risks and uncertainties of stock market investments.

What does this mean?

In my view, and in almost all circumstances, if a Fool has a mortgage and they are a taxpayer, they would be better off paying off their mortgages before investing in the stock market. Certainly all Fools who are 40% taxpayers should pay down their mortgage before investing.

If you are investing in the market and also carrying mortgage debt, you should think carefully about what you are doing. Paying down the mortgage would give you a guaranteed and risk-free return of 12.48% as a 40% taxpayer; investing in the stock market carries risk, and so you should be demanding a risk premium from your stock market investments when compared to risk free investments. This, it has been suggested, should be 6%. This means that, unless you are achieving a stock market investing return in excess of 18% per annum, all 40% taxpayers who are also paying the standard mortgage rate should seriously consider paying down their mortgage first.

But what about interest-only mortages?

What does this mean for people who have taken out interest-only mortgages which they have backed up with investments in index tracker funds? Well, the issue of capital gains tax clouds this a little, as gains made on investments held for 10 years or more would not be taxed at 40% for a top rate taxpayer; but if your investments are not returning significantly more than 12% a year then you would in general probably be better off switching to a repayment mortgage.

If you have any comments you would like to make on this, please pop over to the Fool's Eye View discussion board.

Related links

• Foolish home owning
• The Ten Foolish steps
• Mortgages discussion board
• BBC mortgage calculator