Don't Pay your Mortgage off Early.
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A mortgage is essentially another term for a loan. However, if you stop repaying your monthly mortgage payments (known as defaulting) you could eventually be forced to sell your home. This is so that whoever lent you the money to purchase your house can recoup the amount that is owed to them.
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When it comes to debt, the general rule of thumb is that if the interest charged on your debt is greater than the return you could obtain on your money elsewhere, then you would want to pay your debt off first.
Mortgage rates are currently lower than the long term rate of return in global stocks (7-8% per year). As a result, from a financial perspective, it could be a savvy move to have as long a mortgage as possible if you could earn a greater return elsewhere. I will explain why.
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Below I go through two scenarios, where the interest rate is 3.5% and 10% on a mortgage of £200,000. In each scenario, I compare a 20 year and 40 year mortgage.
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Assumptions
- For the 20 year mortgage we have assumed that once you have finished paying the mortgage off, that the amount at which you were paying the mortgage at will instead be invested into the stock market each month. In scenario 1 for example, the monthly mortgage repayment is £1,160 for the 20 year mortgage. We have assumed that after 20 years and your mortgage is fully paid off, £1,160 will be invested monthly into the stock market.
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- We have also assumed that if you go with the 40 year mortgage, you will invest the difference of the monthly repayment that you would have had to stump up for the 20 year mortgage. For example, in scenario 1 the monthly repayment for the 40 year mortgage is £775, whereas for the 20 year mortgage it's £1,160. The difference between the two is £385 (£1,160 - £775) and this is the amount that will be invested into the stock market on a monthly basis.
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- A 7% annual return in the stock market has been assumed, which is expected of global index funds over the long term.
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Scenario 1 - 3.5% Interest Rate
After 40 years, you will be up by £406k if you went with the 40 year mortgage rather than the 20 year mortgage at a 3.5% interest rate.
This is why as a general rule of thumb, if the mortgage rate is lower than the rate of return you could obtain in something such as the stock market (7% expected return in a global index fund), you will be up from a financial perspective if you go with the longer mortgage term.
This only applies if you actually invest each month alongside paying your mortgage off!
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One of the main drawbacks of paying your mortgage off sooner is that you will initially have more money tied up in a property, than if you paid your mortgage off over a longer period of time. This means that you will have less readily available funds should any situation arise for which you need access to cash.
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Two of the only ways you can extract money from your property is through either:
1) Selling your property
2) Remortgaging to release equity (can be high fees to do this)
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Selling a house normally takes at least 2-3 months, whilst releasing equity from a property through remortgaging takes around 6-8 weeks. Therefore, neither of these options would be much help if you needed money quickly for an emergency.
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Scenario 2 - 10% Interest Rate
If the interest rate on your mortgage was 10%, your total assets at the end of 40 years would be greater if you paid down a 20 year mortgage.
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If you can afford it, in this instance it may be better to pay off your mortgage over a shorter period of time, as you will pay far less interest in total and be able to grow an investment pot much greater.
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It is worth noting that many lenders will allow you to overpay by 10% a year without penalties. Therefore, you could always opt for a slightly longer mortgage term, and overpay when it suits you.
Summary
Should you pay your mortgage off over a shorter period of time? Well, it depends.
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If the interest rate charged on your mortgage is extremely high, I would probably lean more towards paying it down over a shorter period of time.
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You need to consider whether you have other more expensive debts. For example, if you have credit card debt accruing interest at 20% per year and your mortgage rate is 10%, it would be wise to focus on your credit card debt first!
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If you do go for the shorter mortgage as you want to invest the difference between a longer mortgage, you need to consider whether you can rely on yourself to actually do this each month. In situations like this you should set up a direct debit to your investment.
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Taking a step back from the financial implications, you might ultimately prefer the security of knowing that your house is fully paid off. As a result, to sleep best at night you may want to opt for the shortest possible mortgage term.