FOOL'S EYE VIEW
Early Days for Mortgages

By Stephen Bland (TMFPyad)
July 2, 2001

It is debatable whether a mortgage should be paid off early -- assuming one is lucky enough to have the wherewithal to do so, of course. I am not talking here about paying off one loan by remortgaging with another, only about the question of getting the moneylender off your back permanently and before the original allotted timespan.

Before we look at the financial attractions or otherwise of early repayment, I believe that there is a strong emotional element to the question. Many people, and I count myself amongst them, are uncomfortable with all debt and consequently will be pleased to get rid of their mortgage at the earliest opportunity purely on emotional grounds, paying little attention to the financial aspects. As far as I am concerned, and for many others I am sure, all debt is bad so it follows that paying it off at the earliest opportunity is a great relief. I have no figures but I suspect that it is older people in general who may be more likely to pay off  their mortgage early, and younger ones who may not, where both are in the position of having the money available.

So, emotion apart, does it make sense to pay off early? The first thing to consider is whether you are liable to any penalties by doing this. Many loans sold with fixed or capped rates carry an early surrender penalty. That does not mean that it is not worth paying off, just that it is a cost of doing so which must be taken into account if you have this kind of loan.

I see three possible approaches for people who have the money in deciding whether or not to pay off their mortgages early.

1. If you have absolutely no other use for the money, then it makes sense to pay off the loan. Why pay interest to moneylenders if you do not have to do so?

2.The next group will be those who have specific alternative uses apart from risk investments. I am thinking here of perhaps extending your own property, buying a second one for holidays, buying a yacht, a plane or maybe simply keeping it in the bank because you like the thought of all that money sitting there or whatever. For this group it is worth continuing to borrow and pay interest to the bank in order to have these desirable things that give them pleasure. I assume, of course, that they can easily afford the continuing payments.

3. The final group are those who are risk investors and believe they can derive a return from those investments greater than that payable to the bank for continuing to be indebted to it. Such investments would generally be of two types; a second property for letting or some form of equity holdings. The latter would consist of direct shares or funds of some kind, perhaps a mixture of both, maybe with a cash element as well.

The first two groups need no further comment here. It should be fairly clear what to do. The third group is more tricky. What would concern me is that there will be some in this group who may think they have a way to beat the bank and make more returns than interest payable, but who may be deluding themselves or are not fully aware of the risks. I will direct my comments only to equity investors here, rather than property, for reasons of space.

The ubiquitous tracker fund, so often mentioned around the Motley Fool as an attractive long term investment, is one area that needs careful consideration. Think before deciding that investing the money here is preferable to paying off your loan. Although the long-term market growth rate is around 11-12%, it would be dangerous to assume that the growth rate of a UK tracker is more than 8% compound in my view. Yes, that is probably more than the interest you are paying the bank, but how much more? Not a big enough margin to allow for error.

For example, in the last three years the level of the FTSE 100 index has hardly changed. And what if interest rates rise when your loan has exited from any fix or cap? Is a tracker still likely to do the business? Nobody knows the answer but I am suggesting that it is far too low a return compared with interest rates to make this a very attractive proposition. So I would counsel against using a tracker as an alternative to paying off early: for me it is too poor and consequently too risky a deal.

Other methods of investing are more attractive, assuming you have the skill to pull them off. If you are reasonably sure of making returns of, say, 15% plus per year with your investment, then this does become worthwhile compared with paying off your loan. You will naturally be aware that you are taking some risks to do this but there comes a point when you believe in yourself sufficiently strongly to make this something for which you should go. But I would say that only an experienced investor, who has good reason to believe on past facts over several years that he can do this, should even consider it.

The guy who should not really consider investing rather than paying off early is the one who has no track record or perhaps has had one good year through luck rather than a clear strategy that is likely to work over a long period. But such people, should they come into money, are the ones who will be most tempted not to pay off their loans but to risk it in the markets, and this is where the danger arises. It is in fact pretty difficult to make an average long-term return of 15% plus per annum in the stock market. The impression can be gleaned that it is easy but as any experienced investor is likely to confirm, it most certainly is not.

More: the Fool's Mortgage Centre