If you’re a homeowner with a mortgage and you have a little extra money to hand, you may be wondering whether it’s better to pay off your mortgage or invest the money. This is a personal finance question that seems to pop up all the time.
Ultimately, the answer to the question is that it depends on a few different factors. Here, I’ll explain what you need to consider if you’re thinking about either overpaying your mortgage or investing your money.
Check your mortgage
The first thing to consider is whether your mortgage provider will allow you to make extra payments on your mortgage without penalty. Generally speaking, most mortgage providers allow you to pay off an extra 10% of your mortgage balance if you’re in the introductory period and then pay off whatever you want after that.
Yet this is not always the case – some lenders will penalise you for making overpayments in the introductory period. So it’s important to check the terms and conditions of your mortgage first. You don’t want to be hit with large fees for overpaying.
Check your interest rate
Assuming you can make extra payments penalty-free, the next thing to consider is your mortgage interest rate. And more specifically, how that rate compares to the returns you could potentially earn from investing.
Once upon a time, when mortgage rates were high (they were above 15% in the late 1980s), overpaying your mortgage was generally a no-brainer. It made sense to reduce your debt as quickly as possible.
These days, however, it’s a very different story. Today, mortgage interest rates can be under 2%, meaning that borrowing money is very cheap. If you have a mortgage at a rate of 2% and you pay off an extra £1,000, you’re only going to save £20 in interest for the year.
So the question you need to ask yourself is – could you get a better return on your money (i.e. higher than the mortgage interest rate) by investing it?
Higher returns from investing
Personally, I think you can earn a better return on your money by investing it, assuming you’re willing to invest for the long term. Just look at the returns from the stock market over the last five years. For the five-year period to the end of January, the FTSE 100 index generated an annualised return of 5.8%, while the FTSE 250 delivered an annualised return of 8.3%. Looking internationally, the S&P 500 returned 12.4% per year. Meanwhile, the Lindsell Train Global Equity fund returned about 18.4% per year over the five-year period.
If you took that £1,000 I mentioned above and generated a return of 10% for the year through the stock market, your return would be £100 – a better result than saving £20 by overpaying the mortgage.
I’ll also point out that if you put the extra money into a pension, you’d receive tax relief (£1,000 is topped up to £1,250 for basic-rate taxpayers). Similarly, if you put the £1,000 into a Lifetime ISA, you’d receive a 25% top-up. These kinds of top-ups could boost your excess capital even further.
Of course, it’s worth remembering that mortgage interest rates could rise in the future. And stock market returns could potentially disappoint. However overall, I think there’s certainly a case for investing your money instead of paying off your mortgage in today’s low-interest-rate environment.
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Edward Sheldon has a position in the Lindsell Train Global Equity fund. Views expressed in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.