Overpay Your Mortgage or Invest – Is there a simple Yes or No answer & which is better?
As everybody knows at this stage, interest rates on mortgages have shot up recently, especially for those previously fortunate enough to be on Tracker rates. While this may well be the first such increase for many borrowers in well over 10 years, all the indications from the most recent ECB meeting is that further increases are on the way over the next few months. Thankfully those on fixed rates are currently protected from the recent rate hikes but with the cost of borrowing rising substantially for all of the banks, increases for those on variable rates are inevitable over the months ahead. With that in mind, many clients have asked us for some guidance on whether they should consider re-diverting some (or all) of any regular monthly savings they are presently making towards servicing their mortgage quicker by overpaying, so with that in mind we wanted to remind you of some of the benefits of overpaying, as well as offering a real life example of what this might mean in practice.
Without question, overpaying your mortgage can be hugely beneficial, because:
- You will be mortgage free sooner, which has a huge emotionally empowering impact on your state of financial wellbeing,
- You don’t pay interest on the amount you overpay, any overpayment is going directly off the capital,
- The money you might earn on your savings, either in interest, (for deposits), or investment growth, (for unit linked savings), might not beat the interest cost attaching to your mortgage, especially when DIRT or Exit tax are taken into account.
So with the third of these points in mind, let’s look at a real life example.
Sean and Mary have a Tracker mortgage with Bank of Ireland with an outstanding balance of €144,000. Their mortgage has 12 years to run. In June 2022, their repayments were €1,046 per month on a rate of 0.75%, but following the recent ECB rate hikes (0.5% + 0.75% + 0.75%) they are now paying €1,176 per month. Sean and Mary also have a lump sum of €55,000 sitting in a deposit account with AIB following a recent inheritance. Because of the volatility in financial markets since the beginning of this year, and as they are by nature at most medium risk when it comes to their financial decision making, they have left this money on deposit since February, earning them precisely €0 in interest. So with inflation running at 9% right now, the true spending power of their €55,000 is diminishing rapidly.
Sean and Mary asked for our help in making a decision.
So what have we advised?
Well first, as should be a key component in any good financial plan, we made sure that Sean and Mary have an adequate emergency fund to deal with any unforeseen expense, ideally somewhere between 3 and 6 months household net income.
Next, we confirmed they have no shorter term loans, such as car finance or credit card debt, because if they did, clearing that should be their next priority given the higher interest rates associated with that type of debt.
Thirdly, as Sean and Mary came to us before 31/10/22, we reviewed their retirement arrangements and incomes for 2021 and recommended that between them they contribute €16,500 to additional pension contributions for last year, as that was their maximum scope. They immediately actioned this recommendation, as a result of which they generated a tax rebate of €6,600 for the household while also adding €16,500 to investment vehicles which will grow tax-free, namely their pension funds.
Finally, with what was now a remaining €45,000, we looked at what they would save in interest on their mortgage if they were to pay it off in a lump sum, versus what they might make in a medium risk investment.
If they continue as they are, and even if interest rates don’t rise any further (highly unlikely) Sean and Mary will pay €25,344 in interest over the remaining 12 year of their mortgage. If however they pay €45,000 off the loan balance now, and keep their repayments at the €1,176 per month , their loan will be gone in less than 8 years, so apart from the hugely positive impact on their financial wellbeing they will save €13,800 in interest over the next 8 years or so.
If on the other hand Sean and Mary were to invest their €45,000 in a unit linked investment for an 8 year timeframe, in a usually medium risk fund such as Zurich Life’s Prisma 4 fund, while they might expect a return over time of 4% per year (the 5 year average return to end August 2022 is 4.50%) that return is before the annual management charge from Zurich is applied, typically 1% per annum, and before any Exit Tax is applied, currently 41% on the growth. So in reality, even after a positive return of 4% gross per year, the likelihood is that in 2030 the net value of their €45,000 after growth, charges and tax will be in the region of €52,192, a potential gain of €7,192.
In that example so, as you can see, paying the lump sum off the mortgage represents a potentially much more rewarding move for Sean and Mary.
This is obviously only one example of the pros and cons of overpaying a mortgage and it goes without saying that you shouldn’t make any final decision about what to do without engaging financial planning guidance and direction. If therefore you see something of yourself in Sean and Mary, please let us know and we’ll try and help you make the right decision for you, your family and your financial future.