Mortgage Overpayments

Capital Ring
‘T is here, in different paths, the way divides; The right to Pluto’s golden palace guides; The left to that unhappy region tends, Which to the depth of Tartarus descends.

The blogosphere is full of musings on whether one shobuld invest or pay off the mortgage first, and then invest. Both arguments have merit[1].

To invest, or to repay the mortgage, that is the question.
– Hamlet

Cash is interchangeable, so when I buy stocks and shares while keeping a mortgage I’m investing borrowed funds. I am not entirely comfortable with leveraged investing, and I most of what follows should be read with that in mind.

I’m also a higher rate tax payer. To me a personal pension has significant tax advantages. Because: 25% tax free lump sum that can be handed over to the bank at a perky young age of 58 along with a note asking them to please chisel their name off the land register and return the title deeds to my pile of bricks, thanks.

Raise a glass to freedom

Financial success is objectively quantifiable. To an aspiring FIRE’ee, a decision of investing vs repaying the mortgage should be a simple function of tax efficiency and expected risk-adjusted return. Alas, we all carry the baggage of our parents’ views on money, not to mention our own bad financial decisions. It tends to get in the way of rational thought.

Let the past die. Kill it, if you have to.

In 2012 I made a mistake of buying more bricks than I needed by taking on a larger mortgage than I was comfortable with. Because: I had no fecking idea what I was comfortable with, and buying as much house as the bank would allow was all the rage back then.

Now I’m getting I am sick and tired of being tethered to that infernal loan and all that comes with it, such as three-hour remortgage calls where I must discuss my spending habits with a clueless 20-something mortgage adviser, who tells me that £6k in interest and fees over the fixed rate period is cheaper than £5k in fees and interest over the same fixed rate period. I’m tired of having to worry about keeping my job for the fear of losing my home. I hate owing money.

There’s no way I’d pull the FIRE plug without repaying my mortgage first.

Do I hate paying tax more than I hate having a mortgage?

The answer is, mostly, yes.

So this makes a pension – with all its uncertainties and restrictions – my vehicle of choice.

Tax laws may change

Since 2006 there have been more than a dozen changes to lifetime and annual allowance, mostly aimed at reducing the amount I can save into my pension. In addition, both the annual and lifetime allowance have been reduced by inflation. They will begin indexing the lifetime allowance from April this year, but that may also change. Because: Corbyn.

Even without Corbyn, if our fair country’s finances become truly dire, the government may seek to increase tax revenue by abolishing the 25% tax free lump sum. If they were to grandfather the pensions already in drawdown, this could be accomplished with a loss of a relatively small number of votes. We humans are surprisingly amenable to being robbed, provided there is no immediate impact.

How about an ISA then?

When it comes to clairvoyance, I see just as far into the future as anyone else. Having said that, I think that HM Treasury would find ISAs more difficult to tamper with than pensions, and probably less profitable.

ISA savings pots are generally lower, additional tax revenues would be less predictable, and the population of disgruntled voters a lot larger. The annual ISA allowance could be reduced with limited grumbling from the public (the majority of the electorate don’t have £20k p.a. to chuck into stocks and shares), but that’s about it.

Mortgage overpayments vs ISA

My current plan involves retiring at 45 or thereabouts, so I’ll need non-pension savings to tie me over until I’m 58. This makes an ISA not only attractive but necessary.

The opportunity cost of overpaying my mortgage is the tax free investment return I could have had by investing the money in an ISA instead. Historically shares have generated about 7% p.a., which is much more than my current mortgage interest rate. Is it right to compare a long term stock market return with my current mortgage interest rate at a time when stock valuations are at a historic high and mortgage rates are at a historic low? Who knows. ¯\_(ツ)_/¯

ISA contributions come from post-tax income, ditto mortgage overpayments. Investment return inside the ISA wrapper is tax free, but so is any mortgage interest saved by overpaying.

The only sticking point is that ISA allowance can’t be carried over into future tax years. Even on fixed rate mortgage deals overpayments tend to be more flexible than that, and most trackers allow unlimited overpayments. If I fail to take full advantage of the ISA allowance for a few years because I’m busy overpaying my mortgage, then later, having extinguished the mortgage and finding myself with more investable cash than ISA allowance, I’d have to use taxable accounts. I know I’d regret that. Because: I hate paying tax more than I hate having a mortgage.

Mortgage overpayments vs taxable investment accounts

Keeping a mortgage while investing outside the tax wrapper is borrowing to invest without any mitigating factors. That would take larger cojones than I possess, so I’m afraid I’ll have to pass, thanks:

  1. A mismatched risk profile on the asset vs liability side. Investment grade bonds aren’t paying enough to cover my mortgage interest, even before taking tax into account. Hence my hypothetical taxable investment would have to be shares, which are exposed to a number of risks not mitigated by the short position on the mortgage side, such as business, forex (either directly or indirectly via the issuer’s geographical distribution of revenue), regulatory… Monevator wrote about it recently.
  2. Tax. For a higher rate tax payer, expected investment return has to be rather high to make the game worth the candle. FTSE 100 dividend yield is currently 3.9%, so, ignoring dividend allowance[2], my mortgage interest rate over the remaining life of the loan has to be less than 2.6% to break even. Any capital gains will help, but they will be subject to a 20% capital gains tax.
  3. Timing. Given the current CAPE, and the historical relationship between equity valuations and interest rates, the time when I’m likely to be most inclined to decrease my mortgage principle – when the rates go up – is likely to be the time when I’m most likely to be in the red on the invested capital side.

Mortgage overpayments are part of my Fixed Income allocation

Housing costs – in whichever form – are inevitable. As Ermine of Somerset once put it, a hairless mammal in Northern Europe will always need a home. The rule of thumb is that housing should cost up to a third of net income. This would imply that home-owning financially independent early retirees should aim have up to a third of their net worth tied up in home equity.

In addition to the above, I don’t think that a person’s primary residence is an investment in the housing market. I consider my home to be an annuity that will pay my notional rent for as long as I live.

In its essence, home equity is an inflation-linked fixed income instrument, and therefore, assuming a classic 60/40 portfolio, the total value of fixed income securities plus home equity should be less than half of my net worth. It is not. By this measure, I’m very overweight on fixed income vs stocks. Given current PE and CAPE of equity markets, this may or may not be a bad thing, but the point stands.

So what’s the plan then, Sherlock?

It’s a tough one.

Come April 2018, I’ll have no more carry-forward pension allowance. For the first time in what feels like an age there will be more than a few spare pennies to allocate between the mortgage and the ISA.

The case for repaying the mortgage as soon as may be is a solid one. From purely emotional point of view I’d like nothing better than to be rid of it. The whiny little loss avoider inside me would love to be rid of it even if it meant delaying early retirement by a year or two. Regardless of what happens in the markets in the next 10 years, I’d find it difficult to regret owning a mortgage free home.

BUT, financial independence is a numbers game, and numbers tell a slightly different story. I am underweight on equities in the context of my total net worth. Moreover, by trying to not waste a single penny of my pension allowance, I’ve been lately remiss in the article of emergency money. I can use my ISA allowance to rectify for that; a cash ISA can be moved to stocks and shares at a later date.

So, for the coming 12 to 18 months my plan will have to be:

  1. Use up all pension allowance;
  2. Use up all ISA allowance, and put most of it in cash to top up the emergency fund;
  3. Overpay mortgage with whatever is left.

Notes:

  1. Except when people say that mortgage overpayments, by increasing home equity, also increase exposure to the housing market. And so we shouldn’t put all our eggs in one basket, etc. That is nonsense. I took 100% of my exposure to the housing market when I exchanged contracts. The fact that there’s a mortgage is irrelevant: it has no impact on any future (hypothetical) gains or losses I’ll make on my place, and the loan will have to be repaid regardless of what happens to it.
  2. Why can I ignore the dividend allowance? Because: it reduces my pension allowance under the pension taper rules.

13 thoughts on “Mortgage Overpayments”

  1. A regular consideration for myself. As you say once you have used up your carry forward, then for me I would max the ISA first, then mortgage overpayment.
    Depending on how much pension allowance you have with the taper rules, plus 20k post tax income for an ISA, anything else can either go in mortgage overpayments or as tax efficient as possible non sheltered investments.
    Cheers,
    FiL

    Like

    1. I think everyone’s situation is a little different in terms of plans, risk tolerance and tax. I’m staying away from taxable accounts. To the extent that investment income from taxable accounts is to the right of the adjusted income threshold, every £1 costs me £0.20 in pension tax relief, plus there’s the tax on the dividends/ interest / capital gains themselves, so my tax rate on dividends over £5k is effectively 52.5%.
      I don’t think so.

      Liked by 1 person

      1. As you say everyones situation is different, but it depends. I am with you until you get to the top limit of the taper, avoiding any adjusted income is paramount, and I believe by the time you start losing your pension relief I *think* you dont get the dividend allowance, but not sure on that.
        For now for me everything I can in pension and like you, previous years income, and ISAs..
        Cheers,
        FiL

        Like

  2. Love the Hamlet Quote.

    Oh yes, I’m very against mortgage overpayments, especially in the UK where mortgage rates are significantly below inflation. But I’m quite a maths person; cold hard numbers beat any fussy warm feelings for me. I’ve never been fearful of a mortgage, or had the millstone like feeling that someone people report it causes. Also 3 hour remortgage phone calls? Who on earth do you use? I do it in 10 minutes via online banking.

    For what it’s worth, I fill up my SIPP to the limit, my ISA to the limit then a taxable investment account. Not putting any overpayments on that 1.5% mortgage!

    If you plan to retire early, you realise the capital gains year by year to utilise the allowance. Unless there is something even more complicated about the pension taper I don’t get?

    Like

  3. “The opportunity cost of overpaying my mortgage is the tax free investment return I could have had by investing the money in an ISA instead. ”

    Theres opportunity cost even in overpaying vs do-nothing if inflation is > mortgage interest rate. It is, after all, effectively free-money if that is the case.

    A few people have been talking about mortgages in exactly those terms recently, i.e. diversification against inflation.

    Realistically, you almost certainly want to keep some debt on the books, but just at a level your comfortable with – sounds like it may be to large a % in relation to overall net worth currently?

    Like

    1. Do-nothing being spending it or keeping it in cash?
      With cash I think you’d end up in the same place as overpaying minus the interest differential. As to spending it, depends on what you spend it on, right? I recon a basement conversion wouldn’t be a bad investment if you manage to squeeze it in before builders decamp to the continent 😉
      As for debt as % of overall net worth… I’m becoming increasingly convinced that the number I’m most comfortable with is 0.00%.

      Liked by 1 person

  4. Thanks for the post. Interested to know your thoughts on your “use up all ISA allowance and put most to cash to top up the emergency fund” comment. I see tracker investments as being highly liquid i.e. I could sell and receive cash promptly (maybe not same day but 2 days max). I might not want to or like the sales price but if it was a “real” emergency I would sell my holding. I’m also not anticipating any real emergencies where I need cash same day which I can’t sit out or fund from a relatively small float in my current account. I’m therefore more inclined to put the cash to work by investing in shares than sat in cash. It sounds like you look at this differently? Are you holding cash for potential investment opportunities or am I living a boring life and not on the edge enough! What am I missing? Thanks

    Like

    1. I’m not holding cash for investment opportunities. I think it’s very likely that my emergency fund is larger than most 😉
      The thing is, in March 2009 (when I worked for a company whose battle cry up until that point, I though, had been “our people are our product” or “our greatest resource”, or some such nonsense), I sat across a desk from a senior partner (an honorary term for senior execs carried forward from yesteryears) having my appraisal meeting. (And what a clusterfuck of a meeting that was!) The fucker didn’t NOT like me, but I wasn’t in his circle of minions (I was somebody else’s minion), BUT we had a matrix structure, and he was my appraiser. And I was (I thought) a (rapidly) rising star, though at that time still kinda junior(ish) management. I had enjoyed a great deal of slack, people usually smiled and told me what I liked to hear. But it was March 2009, and by then we had gone through 2 rounds of redundancies, the first one voluntary but the second not so much. Now, I’m not trying to make excuses for that ginger asshole so-called partner, but in the redundancies he had lost some of his minions, some of whom I assume he liked. Anyway, it was the financial crisis, the market was weird, lots of cheap distressed assets, lots of interest, people picking and choosing, things kicking off, falling though a week later, then starting again same target different interested party… I told the ginger asshole (he asked the fucking question!) that I didn’t particularly like going from one due diligence project straight into the next, sometimes jumping into a team midway through the project, trying to lead stuff I didn’t always have time to fully understand, and what I really wanted to do was spend more time with junior staff, maybe run a couple of what we called “academies”, sharpen up on my leadership side…. So he looks straight at me and says “You know you’re not paid to enjoy it, right?” I thought it was a semi-joke, but I was wrong. He was dead serious. Anyway, it was a shit meeting, and morale-wise things only went downhill from there, across the Firm. There was a third round of redundancies, which I survived too. But it was never the same. Had I not survived the third round, I would not have been able to find another job straight away. And had I been fully invested in the market before 2008, if I had a fire sale, I would have taken heavy losses. Realised.
      So that’s why.

      Like

  5. Sounds like a tough experience to go through. On the positive it showed you early on how the “game” sadly works in the majority of organisations. Redundancies will likely be a way of life with companies hollowing out middle management roles and more being outsourced to cheaper locations of labour, particularly in banking, M&A, financial roles.

    A few reflections on what you say; most mortgages enable an overpayment reserve to be built up; worst case a mortgage payment holiday could be taken which potentially reduces the amount of “emergency” cash needed to be held. Any redundancy would likely also come with some pay-out / notice depending on length of service which could be factored in to the emergency pot.

    I’m in complete alignment that 0.00% debt is my favoured position. If I’m put in a redundancy situation, a smaller mortgage and monthly outgoings gives me more options. Options may be to look at my transferable skills, set something up on my own or go completely outside of my current career and experience into something totally new and retrain. Although getting to FIRE may take longer as a result, finding something that I find truly/more meaningful in life (or just getting away from the risk of “ginger asshole so called partners”) may be a price worth paying. I hate the HR type saying, but makes sense in this context, it’s ultimately about the journey not the destination.

    Like

    1. It taught me just how precarious my smug little middle class lifestyle had been – an important truth to realise, the sooner the better. As for a different job, I’ve tried that a few times and it hasn’t helped. I think it’s not them, it’s me 😉

      Like

  6. A few other options worth considering.

    – Use an offset mortgage like the one from Barclays. They allow you to offset an ISA against the mortgage. This means you can contribute each year into an ISA with the ability to perform partial transfers out at a later date if you want.

    – Use an IF/P2P ISA with higher and known interest rates. This makes it easier to calculate expected returns against the mortgage interest rate.

    – Using a S&S ISA and in years to come if your returns go well, use it to pay off what remains on the mortgage. Annuity style.

    – Regarding S&S in a taxable account. Think about investing in a low yield fund (income version) with higher expected growth. Then when you retire, switch it to a high yield fund to make use of the tax free dividend allowance.

    Like

    1. I think once I repay the mortgage, commodity ETCs could be suitable for the taxable account. No yield equals no tax 😉 I did look at an offset mortgage last year, but the rate wasnt’ the best; if you have a large sum of money is cash ISAs then the Barclays offset mortgage could be a very good option.

      Like

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s