At some point on the journey to financial independence, most of us will confront a quandary. With surplus cash each month, we’ll begin to contemplate paying off our mortgage early, or instead putting additional money towards financial investments.
But that’s if we recognise that decision as a quandary at all. Because after all, debt has a powerful emotional influence on our decision making.
The decision to pay off a mortgage early isn’t just compelled by financial logic. We want the feeling of full ownership. We want to know that our pride and joy is 100% ours – and we’ll often do what we can to expedite that feeling.
The dilemma can therefore be misunderstood, and our judgement can be clouded by an appetite to see our debt reduce. The thought of debt repayments, 20 years from now, can seem entirely counter-intuitive to the idea of financial freedom.
But the dilemma is a bit more complex than that. To truly understand the opportunity costs of early mortgage repayment, we need to consider time-value adjusted returns on alternative investments, as well as personal circumstances and risk appetite.
The compound power of early mortgage repayment
By making early payments on a mortgage, we can see small incremental reductions compound significantly over the life of the debt. The interest saved through modest increases in a monthly payment can be huge.
Let’s take an example of a 30-year mortgage taken out for £200,000 at a rate of interest of 4%. Assuming we pay according to the normal term, the monthly payment will be £954. The total interest paid on top of the £200,000 will amount to a whopping £144,000.
Now let’s say we decide to overpay each month by £200. That additional £200 each month would save £44,868 in interest alone. It would also mean the debt would be fully paid off some 8 years and 5 months earlier.
You can see the financial effects of early repayment for your own situation by plugging in the numbers on this mortgage overpayment calculator.
Pros of paying off a mortgage earlier
You can begin to see the financial appeal of early repayment, but there a range of other advantages also worth consideration.
- Save money in avoided interest costs. As already demonstrated, the compound power of early repayments on interest can save huge sums of money. Just a small increase in monthly contributions can save thousands in interest costs over the life of the debt.
- Peace of mind. You can’t put a price on peace of mind. Being debt free clears a big financial worry for good. And it means you can focus, free from this financial worry, on putting hard-earned cash towards other things, like passive-income generating financial investments – or maybe just holidays!
- Reduced cost of living. Financial freedom requires a passive income that exceeds living expenses. As mortgages are often the biggest part of our living expenses, they can be seen as a barrier to achieving this balance shift. Paying off a mortgage early clears this living expense burden and can drastically reduce monthly outgoings. This can make financial freedom feel a heck of a lot closer.
- Retirement planning. If you’re close to retirement, clearing down a mortgage liability can be an important part of the preparation. Again, this is about reducing living expenses and ensuring that a hard-earned retirement pot isn’t partially allocated to servicing debt.
Cons of paying off a mortgage earlier
You can quickly see how we can develop an emotional response to this decision. Debt free, closer to financial freedom, peace of mind – it sounds like a no brainer. But the reality is that paying off a mortgage early can carry significant opportunity costs, depending on your investment mindset.
- Lost leverage power. A mortgage offers you probably the cheapest credit you’ll ever get. This is the case now more than ever in economic history. Meanwhile, we know that long-term investment returns on equities, for example, are likely to outstrip this interest cost saving considerably. Assuming these lower mortgage rates prevail over the longer term, and assuming we’d otherwise use our early repayments to invest in outperforming asset classes, paying off our mortgages early will be foregoing financial gains. But those are some big assumptions, and this also assumes you’ve got the risk tolerance to put all this spare cash towards these other investments.
- Reduced liquidity. Putting additional cash towards a mortgage means more money tied up in property. The problem here is that property is much less liquid than financial assets. In other words, you can’t get at the money immediately if you need to. Selling property can take 3-6 months, maybe more, so if there’s a chance you’ll need cash fast, paying off a mortgage early is unlikely to be a sensible choice.
- Lost diversification. Higher inflation erodes currency purchasing power. The importance of a mortgage is that it hedges against this risk. By holding debt denominated in the affected currency, we are effectively ‘shorting’ against this currency exposure. What does that mean in practice? It means the risk of inflation sits with the financial provider. And as well as losing that hedging against inflationary risk, early repayment means we expose ourselves to a less diversified asset portfolio. By increasing investment in our home, what asset classes are we foregoing in the meantime? Diversification provides some level of protection against investment risk.
- Lost inflationary advantages. It may have been unheard of before the 2008 financial crisis, but when interest rates fall below inflation rates, borrowing wins. Effectively, it means you’re being paid to borrow. Paying off early in such circumstances offers no financial advantage. In fact, it potentially just exposes your asset portfolio to more risk.
Things to do before paying off a mortgage early
This isn’t an easy decision by any stretch. While financial logic suggests investing the money elsewhere may be the better long-term option (if numerous assumptions hold constant), sometimes decisions can’t be framed solely in a financial light.
Whatever you decide, here are a few sensible examples of things that shouldn’t be shelved in favour of early mortgage repayment.
- Pay off higher cost debt. As you work your way through reducing debts, address the debt carrying the highest rate of interest first. Again, this is about recognising where power of leverage can have financial advantages – and where it most certainly doesn’t. So if you’ve got a credit card debt at 8% interest and a mortgage at 3% interest, focus your attention on bringing down the credit card debt before considering early repayments of the mortgage.
- Ensure you have a suitable emergency fund. Before committing extra cash to towards a mortgage, it’s important to ensure you have enough cash to provide protection in emergencies. The general advice is that emergency funds should be at least 6 months of living expenses, but this can vary depending on the risk profile of your profession, among other factors. For more on emergency funds and how to determine an appropriate level for you, read my article here.
- Maximise employer matching on pensions. Employers typically offer pension matching via defined contribution schemes. Before paying considering early mortgage payments, ensure you’re getting the most from your employer’s contributions by maximising your own.
Financial decisions are full of quandaries between emotional intuition and financial logic. The decision to pay down a mortgage early is no exception. Emotional intuition weighs heavily on the decision. And sometimes that can’t be ignored, despite the financial arguments.
A well-diversified portfolio of equities would outperform the financial gains of paying down a mortgage early, assuming returns are consistent with economic history and interest rates remain low. What’s more, paying off a mortgage early will forego the inflationary hedging benefits.
But that may not feel like enough for some. Paying off a mortgage can bring tremendous peace of mind. It can feel like a giant step towards financial freedom, even if it’s not mathematically the soundest approach.
And this isn’t a binary choice. You can combine the approaches. Sure, this might be contrary to the financial logic, but at least it would assuage some debt worries. In fact, my own approach follows these lines. I’m making early mortgage repayments now to reduce my future monthly payment when I’m financially independent. Meanwhile, I can use surplus cash to invest in other asset classes.
As counter-intuitive as it sounds, financial decisions sometimes cannot be entirely predicated on financial mathematics. Weigh the decision on its financial and emotional merits. And remember: this is a good dilemma to have.