When interest rates are high, deciding whether to pay off your mortgage or invest cash reserves can be challenging, but you do have options.
There is a longstanding financial maxim that if people come into money – or are holding cash reserves – they should pay off their debts first, rather than invest.
That concept is being re-examined in the UK due to interest rates – and, therefore, mortgage lending rates – reaching highs not seen since the 2007–2008 financial crisis. Around 800,000 households in the UK are facing the prospect of interest rate rises when they renew their fixed-rate mortgages in the second half of 2023, with another 1.6 million deals due to end in 2024.1
For those in the fortunate position to be able to pay off their mortgage early – after receiving a substantial annual bonus or an inheritance, for example – rising interest rates may make early repayment appear an attractive option. But there are key questions they need to consider before making the decision.
“It depends on many factors but it’s ultimately up to each individual, their circumstances and their financial goals,” explains Chris Matthews, managing director at RBC Wealth Management in the British Isles. “What do they want to achieve with their wealth? Build a nest egg to pass onto the next generation? Prepare for retirement? Make a specific purchase?”
“Some of our clients don’t like having debt and prefer to pay things off, while some are comfortable having debt on an ongoing basis because the potential returns from investing are higher than the interest they’ll pay on that debt,” Matthews says.
Timescale is also a key factor. If you’re planning to retire soon, for instance, you will likely need to look at things differently than people who are not near retirement age. Also, attitude to risk is central to how people approach investing.
So, should you pay off your mortgage or invest? It can be a challenging question. Typically, clients have several options: invest the full amount; invest some and pay down some debt; or pay off debt and don’t invest.
You might want to ask yourself, “Will my potential returns from investing be higher than the interest I’ll pay on my debt?” If someone can make a seven percent return on investment, while the interest rate on their mortgage is only four percent, then the argument seems straightforward.
Faisal Manji, director of Global Manager Research at RBC Wealth Management in the British Isles, says, “Assume your fixed-rate mortgage term has just ended and you have £1 million left to pay. If you take a five-year fixed-rate repayment mortgage at five percent, then the total interest payable over the term would be around £132,000 – that’s how much you’d save if you paid the £1 million off with lump sum.”
“If you instead invested that £1 million over five years, you would need a compound annual growth rate of 2.52 percent to equal the interest burden,” he continues. “Considering that in June 2023, a five-year UK gilt – a conservative investment option – was returning 4.53 percent and UK equities had an expected annualised return of 7.1 percent, then the investment route is pretty compelling, even after tax.”2
Yet interest rates (and, therefore, mortgage rates) may rise and stock markets may fall. Manji, however, says that while interest rates aren’t likely to return to the lows we have seen in recent years, there are limits to how much higher they can go.
Investors have a number of investment options available to them, from fixed income and equities to more alternative asset classes that together, or in combination, can create a balanced portfolio that aligns with your attitude to risk.
If you take the investment-only route, you will need to consider the impact of capital gains and income tax on returns, unless you are able to access tax-protected growth through vehicles such as individual savings accounts (ISAs) or pensions. Speaking with a wealth planner can help you map out the most suitable option for you.
With investment – be that in fixed income, equities or other asset classes – painting such a compelling picture, why would a client pay down or clear a mortgage instead of investing?
In some instances, the decision may come down to an individual’s mindset – they simply prefer not to have debt. “We have clients who take out a mortgage to buy a property and then, 18 months later, they receive a bonus that enables them to pay it off,” says Matthews. “They may well have only ever viewed the mortgage as a short-term loan, with the full intention of paying it off as soon as they could.”
For entrepreneurs and business owners who have everything invested in their business, owning a home outright may give them a measure of security: if the business doesn’t succeed, then at least they have the roof over their head.
Similarly, those close to retirement that will suddenly be without a regular income may prefer to have paid off their mortgage.
There is an emotional aspect to this decision as well – being mortgage-free may be something you’ve always aspired to be.
While all these reasons are understandable, Alex Yates, managing director and head of Credit Underwriting at RBC Wealth Management in the British Isles, sounds a note of caution: “If you intend to pay off a mortgage, you need to check whether there will be a penalty for early repayment, or for overpayments if you’re not paying the full amount,” he says.
“If so, then it might not be as attractive to pay it down. It’s also essential to note the illiquid nature of property should your circumstances change and you find yourself needing immediate access to funds.”
There is a middle ground between these two options, and that is to do both.
While taking this route means you won’t necessarily benefit fully from potential investment returns, neither will you be tying up that entire lump sum in your property; so at least you’ll retain some liquidity.
“Investors each have their own tolerance and capacity to take risk, and their own personal set of financial goals,” says Manji. “So it makes sense that some individuals will want to balance paying down debt whilst also investing.”
Timescale is also important here, adds Matthews. “For those who receive a substantial annual bonus, any decisions they make now may well be done with that in mind.”
As much as some people may be torn between paying off a mortgage and investing, one thing is for certain: doing nothing and simply sitting on cash reserves can mean you miss out on potential opportunities.
It’s understandable, however, that you might not want to use your available cash to pay down a mortgage. It’s also possible that market volatility means you aren’t willing to take the risk in equities, yet you don’t want to get locked into a fixed-income investment.
“Rather than sitting on cash, one option would be to take advantage of a revolving credit facility,” explains Yates. “These allow you to pay down part of a mortgage while also allowing you to redraw against the mortgage at a later date – when, for instance, you need the funds for something specific, the markets are more favourable, or you are anticipating a capital call.”
Paying off a lump sum of this type of mortgage will reduce repayments and interest charges until any amount is redrawn.
The reality is that choosing between investing and paying off a mortgage isn’t always a simple decision.
When interest rates are high and there is market uncertainty, try not to make knee-jerk decisions and withdraw existing investments in order to pay down a mortgage.
“Anyone facing this scenario will have their own unique circumstances, and the role of wealth planning and investment advice can’t be understated,” Manji says.
1 UK Finance .
2 Rate correct as of 23/6/23, Blackrock Capital Markets.
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