FOOL'S EYE VIEW
Gearing And Paying Off The Mortgage

By James Carlisle
April 26, 2002

The effect of a mortgage, and the 'gearing' that goes with it, is to magnify the returns you make on your home - both positive and negative.

If you borrow £80,000 to buy a house costing £100,000 and the value of the house goes up just 20% to £120,000, then the £20,000 that you put in will have doubled to £40,000. Fantastic! Of course it works the other way as well and if the value of the house falls to £80,000, then you'll have lost the whole of the £20,000 you put in. Not so fantastic!

So gearing increases your risks but, if you have reason to believe that your investment will generally give you a higher return than the cost of your borrowing, then it can work very well.

Thankfully, there are very good reasons to think that the returns you get from your home (comprised of the rent you don't have to pay, plus any house price growth) will exceed the cost of a mortgage over the long term.

If you think about it, the market has to work so that the combination of rent and house price growth exceeds the cost of borrowing money (and what you could get on savings in the bank). Otherwise, there would be no landlords as they would all have their money in the bank. Rents and house prices, not to mention interest rates, have to find a level in the market whereby it makes sense to own real assets like property over the long term - precisely because they have to be owned by someone.

If they weren't worth owning, then people would sell them until the price reached a level where they were worth owning again.

So, you may get some wobbles in the short-term, but over the long term things should work out and on that basis, we shouldn't be too worried about a bit of gearing. Because of the short-term wobbles, however, you have to make sure that you can make it through to the long term and that means making very sure that you don't overstretch yourself.

You also shouldn't think of gearing as being something exclusively linked to your home. Your mortgage will be secured on the house, but you may (and hopefully do) have some other assets as well. So, if you have a mortgage of £75,000 on a house worth £150,000, then you're in essentially the same position as if you had a £75,000 mortgage on a £100,000 home, with other investments worth £50,000. In both cases, you owe 50% of your net worth.

Interest-Only and Repayment Mortgages

These same arguments can be extended to the question of interest-only and repayment mortgages. With the former, you only pay interest during the course of the mortgage, the plan being to pay back the capital at the end. With the repayment approach, on the other hand, you pay back some of the capital each month. So the monthly interest bill gets less and less, allowing you to pay back more and more capital so that by the end of the 25 years, it's eventually gone. Since you're not paying back capital, the repayments on the interest-only mortgage will be lower, allowing you to build up a pile of investments (that you'll eventually need to pay off the mortgage).

Of course, one of the effects with the repayment approach is that your gearing reduces as time goes on. But you'd expect this to happen anyway with both approaches because, over the long term, you'd expect the price of your house to be increasing (see note 1 at the end).

Take a property worth £100,000 and a mortgage of £80,000. With an interest rate of 6% (see note 2 at the end), you'd need to make monthly payments of £507.70 on a repayment mortgage to get rid of the thing after 25 years. With an interest-only mortgage, you'd be paying £389.40 interest each month and adding £118.29 to your investments (see note 3 at the end).

Over the years, you might expect the house, your mortgage, your home 'equity' and your investments to develop something like this. (For an explanation of the various assumptions, have a look at the notes at the end.)

Repayment Mortgage

Year       House   Mortgage     Home   Investments   Investments
           Value    (£'000)   Equity       (£'000)     Plus Home
         (£'000)   (Note 2)  (£'000)                      Equity
        (Note 1)                                         (£'000)

0            100        80       20              0            20
5            125        72       53              0            53
10           155        61       94              0            94
15           194        46      148              0           148
20           241        26      215              0           215
25           301         0      301              0           301

Interest-Only Mortgage

Year       House   Mortgage     Home   Investments   Investments
           Value    (£'000)   Equity       (£'000)     Plus Home
         (£'000)             (£'000)      (Note 3)        Equity
        (Note 1)                                         (£'000)

0            100        80       20              0            20
5            125        80       45              8            53
10           155        80       75             19            94
15           194        80      114             34           148
20           241        80      161             54           215
25           301        80      221             80           301

As you can see, it doesn't make a whole heap of difference which approach you take. Assuming the same rate of growth on your investments as the interest rate on the mortgage, you end up with the same net worth overall - £301,000. It's just that with the repayment mortgage you end up with a split of 301/0 between house and shares and with the interest-only mortgage you end up with a split of 221/80.

Even if your shares do badly and end up being worth half as much as you'd hoped, you'll end up with a split of 221/40 (a total of £261,000). If they end up being worth twice as much, you'll have a split of 221/160 (a total of £381,000). Neither result is dramatically different from the 301/0 under the repayment mortgage.

Far more significant, for most people, will be what they do with the equity that builds up in their home over the years. Imagine that you move to another house of the same value after 10 years and again after 20 years. On each occasion, you increase your mortgage so that you're back up to 80% gearing (and extend the mortgage to another 25 years) and invest the money you take out. By going the repayment route, you'd end up with a home equity/shares split of 128/283, whereas by going the interest-only route, you'd get a split of 108/303. These figures are not very different from each other, but both are dramatically different from sticking with your original mortgage.

Note that you have £411,000 in total now instead of the £301,000, because we've factored in bigger payments to cope with the bigger mortgage. You can quite easily make those extra payments without getting a bigger mortgage!! What you absolutely don't want to do is to keep increasing the mortgage and spending the money (school fees, a new car, you know the sort of thing). That way you'd end up with a big mortgage, not much equity, no investments and a cold retirement.

So the arguments for and against interest-only or repayment mortgages tend to miss the point, especially when people are moving house frequently. What really matters is that you:

(a) you stay well within your means on both your house and your mortgage;

(b) have a balance of equity in your home and other long-term investments that you're comfortable with (as ever, a bit of both is generally a good answer); and

(c) save, or pay off the mortgage, or preferably both, very hard!

More: ISA Centre, Homeowning Centre

Note 1 - Over the long-term, house prices tend to grow roughly in line with growth in average earnings. In the past, this has been relatively steady at about 2% above inflation. So, given an inflation target of 2.5%, we might expect growth in average wages, and therefore in house prices, to be about 4.5% per year.

Note 2 - I've assumed interest rates to be 6% for the duration of the loan, a 1% premium to the 25-year bond yield.

Note 3 - I've used the same growth rate on the investments as the interest rate for the mortgage - just so things work out the same in the end. In practice, you'd hope for a better return from the stock market than the interest rate you pay on the mortgage and you'd therefore hope for a better result from the interest-only mortgage (for a little more risk of course).