Paying off your mortgage versus investing

• Level: For advanced
• Reading duration: 8 minutes

At a certain point in your life, there’s a fair chance you’ll be faced with the following dilemma:

1. Option 1: Do I use my extra cash to pay off my mortgage early?
2. Option 2: Do I invest my money in a bid to earn greater profits and perhaps pay off my mortgage even earlier?
3. Option 3: Forget about my dilemma and just spend it all on having a good time now! (Tempting but we cannot recommend this approach.)

The dilemma hinges on the following trade-off:

• Overpaying the mortgage offers a set return that will reduce your overall interest payments and shorten the duration of your loan
• Vs the potential for higher returns in the stock market

Equity returns have historically beaten mortgage interest rates over the long-term, but this outcome cannot be guaranteed because there is no reward without risk. All told, the mortgage versus investing question does not have a one-size-fits-all answer. But we can explore the pros and cons of each option, and talk about the financial and personal circumstances which may tip the balance for you one way or another. £350 monthly pension contributions (This is a £ 200 net contribution plus £ 150 in retirement saving incentives) OK, let’s make the best case we can for each option, then walk-through the full mortgage versus investing calculation afterwards.

The case for paying off your mortgage

Pros

• Peace of mind: Watching your mortgage debt decline feels good and champagne corks will fly when it finally hits zero
• Interest savings: Shrinking interest payments relieve pressure on your monthly finances and help you withstand interest rate shocks or employment insecurity in the future. Early repayment means you’ll pay less interest overall 
• Guaranteed return: As mentioned previously, paying down your mortgage provides a guaranteed return equivalent to the interest rate on your loan. For example, if your mortgage rate is 5%, paying it off early gives you a risk-free return of 5%
• Building equity: You’ll typically qualify for a lower interest rate (and more merciful loan charges) the lower your loan-to-value ratio. In other words, the higher the value of your home versus the loan size you require, the more likely it is you’ll qualify for a better remortgaging deal in the future. Obviously this matters much less if you’re on a 20-year fixed rate mortgage than if your mortgage is up for renewal in five years

Cons

• Opportunity cost: The primary downside is the potential opportunity cost. Money used to pay off your mortgage cannot be invested elsewhere, so could miss out on higher returns from the stock market
• Liquidity: Once you pay off your mortgage, that money is tied up in your home. It’s not as easily accessible as wealth in most investment accounts
• Loss of tax breaks: Paying down your mortgage can mean missing out on tax incentives to save for your retirement. If you can’t max out your retirement tax advantages and overpay your mortgage then consider which incentives you really don't want to lose. For example, in the UK, foregoing your employer contribution is like failing to pick up free money. Similarly the boosts from the Lifetime ISA government bonus and 40% pension tax relief are too good to miss, and may not be available in the future 
• Early repayment charges: Check your mortgage agreement. Avoid overpayments that incur annual charges for paying off too much, too soon. Also beware of excessive charges for eliminating the entire loan before your term ends. Sometimes these charges are negotiable, so push your mortgage company for a better deal next time, if you’re likely to fall foul of these clauses

The case for investing

• Higher potential returns: Historically, the stock market has provided higher average returns than the average mortgage rate. For example, the long-term annualised return of the MSCI World is around 9.5% p.a. This is significantly higher than current mortgage rates.
• Diversification: Investing allows you to diversify your assets, reducing the risk of having too much of your wealth tied up in a single asset class (your home).
• Liquidity: ETF investments are much more liquid than property. You can sell ETFs at the touch of a button if you need access to cash (so long as it’s not locked up in a retirement account).
• Long-term investing: You have a better chance of achieving the average returns quoted above if you stay patiently invested for years. In the short-term, anything can happen with equities. They can register big annual gains and drops, and even years of “meh” performance. But over time, returns tend towards the average:

  MSCI World performance over a long period

  Source: justETF Research, as of 02/2024
  This graph shows the range of outcomes (best and worst) over any investing period up to 25 years long. You can see that you’re more likely to achieve the average return (blue line), the longer you remain invested
  The upshot is that you’re better placed to outpace your mortgage if you invest in a diversified World equity ETF for two decades versus hoping for the best over a handful of years
• Tax advantages: As covered in the ‘Loss of tax breaks’ section above, look out for direct subsidies, tax-reliefs, tax-free and tax-deferred accounts that tilt the playing field in favour of investing. That goes double if you think the tax system will be less generous in the future
• The power of compound interest: This is the snowball effect of interest earning interest. The effect is most pronounced when given time and high returns to work with. Because investment returns (effectively a form of interest) are typically higher than mortgage rates, and you can automatically reinvest your gains in accumulating ETFs, you’re more likely to benefit from the power of compound interest through investing
  Compound interest only works with a mortgage if the extra disposable income freed by overpayments is ploughed straight back into the mortgage (or used to invest). Even then, comparatively lower mortgage rates restrict the compound interest effect versus investing.

Cons

• Market risk: Investing in the stock market involves risk. The value of your investments can fluctuate, and there’s no guarantee of returns
• Reducing risk: At some point you’ll want to cash in your investments. If a large chunk is earmarked to pay off your mortgage then it’s common practice to gradually derisk your position several years in advance. For example, you might move a percentage of your portfolio per year from equities to a government bond or money market ETF. The upside is you’re less vulnerable to a stock market crash, the downside is you can’t expect equity-like returns from lower risk assets
• Costs: Investing incurs charges such as management fees, transaction fees, broker fees, and potentially taxes on capital gains and income. Hammer down these costs to extract maximum value from your investments. Choose low cost ETFs and an ETF saving plan harnessed to a tax-advantaged account to minimise your fees

Young investor vs older investor

There is a wrinkle that’s rarely mentioned in the paying off your mortgage versus investing debate. Inflation reduces the burden of your mortgage debt over time. Moreover, you’re likely to earn a larger salary and enjoy more disposable income as your career progresses. Those dynamics typically make it easier to reduce your mortgage later in life, so long as you don’t continually upsize your home at every opportunity. Conversely, we also tend to become more risk averse as we age, making it harder to invest purely in equities. Hence there’s a good argument for investing as early as possible - to make the most of the compound interest effect and the courage of youth - while backing yourself to smash the mortgage in the future.

Pay off the mortgage AND invest

No matter which way you slice it, both paying off the mortgage and investing for a happy retirement (or other important financial objective) need to be done. One perfectly rational strategy is to hedge your bets and use 50% of your extra cash to pay down the mortgage while the other 50% is invested. That way you feel the immediate benefit of reducing your debt burden while positioning yourself to reap the reward of future stock market gains.

Paying off the mortgage versus investing: the calculation

If you use an online calculator then the simplest solution is to compare your current mortgage interest rate versus your expected investment return. Many people use the long-term average performance of a broad index like the MSCI World as their expected equity return. You may wish to model scenarios where the return is less than expected to build in a safety margin. The current yield of 10-year Eurozone government bonds or 10-year gilts for UK is a reasonable stand-in for expected bond returns. The other factors we need to consider are:

Putting it altogether

As you can see, it’s a tricky calculation with quite a few moving parts and the average online calculator isn’t built to handle it. If you want to come up with a rough comparison between the two options then:

• You can use a mortgage payoff / overpayment calculator when the only differential is your expected investment return vs your mortgage interest rate
• Or: Pair a mortgage payoff calculator with an investment return calculator when your investment option benefits from tax advantages and subsidies

This is how to do it ...

Scenario: 5% mortgage rate versus 10% expected investment return plus retirement account advantages

• Monthly contributions = £350 investment (including retirement incentives) vs £200 monthly mortgage overpayment
• Mortgage remaining = £300,000
• Investment term = 17 years (The time it takes to pay off the mortgage using £200 overpayments)

Now compare these details using an investment return calculator. First simulate:

• £200 monthly mortgage overpayment
• 5% return
• 17 year timespan
• £0 starting amount

Result:

• End balance = £64,105
• Interest earned = £23,305

The end balance is the amount the overpayments wiped off your mortgage. The interest is your 5% return compounded. Impressive. Next simulate:

• £350 monthly pension contributions (This is a £200 net contribution plus £150 in retirement saving incentives)
• 10% return
• 17 year timespan
• £0 starting amount

Result:

• End balance = £186,292
• Interest earned = £114,892

The end balance is the amount of wealth built in your retirement account. The interest is the 7% return compounded. Very impressive. Verdict: You’ve nearly tripled your money by investing in a retirement account. You’re clearly better off paying into your pension in this scenario while reducing your mortgage via standard repayments.

Alternative scenarios

This time, let's assume a low long-term mortgage rate of 1% but also a more cautious 7% investment rate estimate. We're still contributing £200 a month but there are no retirement incentives on the investment side.

• 1% mortgage rate: you pay down the mortgage in 17 years and 3 months. Almost three years earlier than without overpaying.
• 7% investment rate: you build enough wealth to pay off the mortgage in 16 years and 11 months (in a tax sheltered account exempt from dividend tax and capital gains tax.)
• Verdict: Overpay the mortgage. It’s a guaranteed win whereas wiping out the mortgage four months early via investing is not worth the chance that you may fall short.

And if we go with a 1% mortgage rate and 9.5% investment rate for your expected returns (9.5% - 0.5% investment fees = 9% annualised), the result is:

• 1% mortgage rate: you pay down the mortgage in 17 years and 3 months. Almost three years earlier than without overpaying.
• 9% investment rate: you pay off the mortgage in 16 years and 9 months (in a tax sheltered account exempt from dividend tax and capital gains tax.)
• Verdict: Overpay the mortgage. Even eliminating the mortgage six months early doesn't compensate for the risk of your investments underperforming. 

Making your decision

As you can see, the right choice depends on various factors:

1. Interest rates: Higher mortgage rates make overpaying more attractive, while lower rates favour investing
2. Tax situation: The tax implications of mortgage interest payments and investment returns can be decisive. Retirement accounts may especially stack up enough incentives to create a clear case for investing above overpayments
3. Risk tolerance: Paying off your mortgage is a guaranteed return, while investing carries risk but also the potential for higher rewards
4. Time horizon: A longer time horizon generally favours investing due to the power of compound growth
5. Personal goals: Some people prioritise being debt-free, while others are comfortable with mortgage debt if it creates the opportunity for greater wealth accumulation
6. Diversification: Consider your overall financial picture. If most of your wealth is tied up in your home, investing might provide needed diversification

Remember, this doesn't have to be an all-or-nothing decision. A balanced approach could be:

1. Make sure you're contributing enough to retirement accounts to capture any employer subsidies and generous tax reliefs
2. Consider splitting your extra money between mortgage overpayments and investments

This strategy allows you to work towards multiple financial goals simultaneously, balancing risk versus reward, and potentially increasing your overall financial well-being. Remember, your decisions don't have to be static. As your situation changes, you can adjust your strategy accordingly.