The question that many people have been asking me recently in light of the ECB reducing their refinancing rate a couple of weeks ago is - when rates go down and they are now paying less than they were a month previously should they continue paying what they had been? And also if they have money sitting on deposit, should they use it to pay off their mortgage early or invest it given how low deposit rates are?
The problem as I see it is that the answer, is a little bit more complex than some would lead you to believe so I am going to try help you make a balanced decision based on what your instinct is telling you to do along with making a smart financial decision that is best suited for you.
My gut (emotional) reaction when I am asked this question is normally to say get out of debt. And this is probably because it has the following benefits:
The security of owning your own home.
It gives you that peace of mind knowing that if you lost your job or suffered an illness that prevented you from earning an income ever again that you won’t be in danger of ever losing your home to repossession.
One less monthly outgoing to deal with.
A mortgage repayment for most is their single biggest monthly outgoing and without it you would have more money to spend, save or work less etc.
And of course if you pay off your mortgage early you could save thousands in interest payments that would have otherwise gone to your bank.
The downside (unemotional) decision to paying off your mortgage early as I see it is:
Poor return on investment
If you have a tracker mortgage, this is likely to be the cheapest money you will ever borrow in your lifetime so could a long term investment provide a higher return on your capital if invested rather than used to repay a mortgage?
The answer is absolutely – if you had a tracker mortgage at an average rate of 2% with 20 years remaining and you owed €200,000 - if you overpaid it by €100 each month you would save €7,801 in interest payments to the bank.
However, if you deposited that same €100 into a regular savings account with an average rate of 4%, you would accumulate interest of €21,755 in that same time period.
So, from an emotional point of view, your €100 as an overpayment against your mortgage would take 3 years 4 months off the term and that is something you might like to see happen - “I want to be debt free as soon as I can” but from an unemotional financial point of view you would be better off saving that money because you would earn nearly 3 times as much on deposit than the mortgage is costing you. The caveat with this scenario of course is that you can continue to make the monthly repayments.
Savings come later, much later
This is an important point to be aware of because you won’t see the savings until after the mortgage is paid off. And here’s what’s interesting, look at what happens to those savings, when they are, discounted for inflation. Let me explain further, if your monthly repayment is €1,000 and that amount is saved 25 years into the future because your mortgage is paid off, then that amount is really only a saving of €562 in today’s terms if you factor in inflation at an average of 3%. In other words you have to discount all your future savings by inflation because the payments you avoid in the future will have depreciated in value.
And here’s another thing to be mindful of, if interest rates were to ever be less than the inflation rate, then a situation would arise where you are literally being paid to borrow money in real terms even though you are paying interest each month – you make more by owing than by owning – this is strange but true.
The advantages to paying off your mortgage early are fairly obvious for all to see but not the two negatives I have just pointed out. Yet they are as valid to your bottom line as the instinctive reasons for paying off your mortgage.
The difficulty for many people making a decision like this is being pulled from making that emotional decision i.e I don’t care if I make more on deposit, I would just feel better having no mortgage to the unemotional one i.e just what the bank want me to do, why give them debt forgiveness when I could make more on deposit than what my loan is costing me?
The answer to this question ultimately will depend on what type of mortgage you have and what term is remaining on your mortgage –if you have a variable or a fixed rate one, then it is unlikely you will get a better after tax return than what your mortgage is costing you (if your lenders variable rate is 4.5% to get the equivalent rate in a regular savings plan, you would need to be earning circa 7.60% gross which of course is not on offer from any bank) so if you have surplus funds each month or money sitting in an account that is not your emergency fund and you don’t have any other debt that is higher than your mortgage i.e credit card debt then yes you should use funds to pay it off as quickly as possible
If you have a tracker mortgage and you can afford to continue to make the monthly repayments then I would invest my money rather than using it pay down your mortgage debt.
Let me finish by telling you what I do – I am lucky to have a tracker mortgage. I don’t overpay each month, but I do pay every two weeks so I make 13 rather than 12 repayments each year so I suppose I am overpaying! By doing this I will reduce my mortgage term by three years five months. I could overpay each month as well but I calculated that if I did, I would pay c. €5,646 less in interest repayments but that same money in a regular savings account is going to net me €13,598 over the same term and better in my pocket than in BOI’s!