Should you overpay your mortgage or invest?

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Financially speaking, the coronavirus pandemic has affected all of us differently.

Some, through furlough or redundancy, are significantly worse off.

But for many others, being able to work from home has meant huge savings. Gone are the costs associated with the commute for example, and meals out and holidays have been replaced with… well, not much to be honest.

Homeowners who now have a sizeable chunk of savings may well be wondering if there’s more they can do with their money.

After all, interest rates on savings are at an all-time low, and with news this week that inflation in April, as measured by the Consumer Prices Index including owner occupiers’ housing costs (CPIH), has jumped to 1.6%, most savings accounts are now effectively losing money over time.

Here’s a handy guide on why that is.

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The best use of your money

If you have any high interest rate debts, such as a credit card debt, personal loan or overdraft, now is definitely the time to pay them off.

You should also make sure you have an emergency fund somewhere easily accessible, which should be at least three months’ worth of living expenses but ideally around six.

Unfortunately this is best practice even though interest rates are so low. There are a couple of places where you can still get inflation-beating instant access savings though – click here to find out more.

Is it better to overpay your mortgage or invest the money?

If we are just talking about the numbers, that is, which option will perform better financially, it actually depends on a myriad of factors, including the length of your mortgage and the interest rate on it.

I’ve put together a spreadsheet where you can plug in your own numbers (just make a copy and save it locally) to make the comparison a little clearer.

It captures two scenarios, both with a budget fixed to the maximum amount you can repay at the start of your mortgage.

In the first, you maximise your overpayments on top of making your regular repayments.

I’ve assumed that it’s a fixed rate repayment mortgage (rather than interest only) and that you’re allowed to make up to 10% in overpayments each year without penalty.

As you pay down your mortgage, the amount of overpayment you can make decreases each year so I’ve assumed that you’re going to invest the surplus money.

In the second scenario, you don’t make any overpayments – just your normal mortgage repayments; the money you would have used for overpayments are instead invested.

To see which one works out better financially, you have to compare the two wealth columns. Depending on your figures, one scenario should outperform the other for a couple of years before the two switch around.

To be clear, even though you can adjust the numbers based on your circumstances, these are estimates only. Because aside from the fact that it’s impossible to predict investment returns (see below), this is an imperfect model.

Pros and cons of investing

Firstly, as ever with investing, past performance is not an indicator of future returns so even if there’s a historical rate for average returns, there’s no guarantee that you will hit that number.

The returns could be less than what you would have saved on your mortgage interest. What’s more, you could even lose everything, which is why it’s important you should never invest what you can’t afford to lose.

Invested money is theoretically more liquid than overpaying your mortgage though – you can generally request to have your money transferred back to your bank account within a couple of days.

If you have a stocks and shares ISA, you can take advantage of the tax benefits that will give you as well.

There are also different types of investing, with varying levels of risk.

If you are considering investing a significant amount of money, make sure you know the risks and speak to a qualified financial adviser who’s authorised by the Financial Conduct Authority to give investing advice.

Here’s a guide to getting started with investing to start your research.

Pros and cons of overpaying your mortgage

The benefit of overpayments is obvious: you’ll pay off your mortgage sooner and save lots of interest in the process. And unlike investing, the amount of interest you save is guaranteed.

Plus, as you’ll have more equity in your home, it’s also easier to remortgage if you want to trade up for a bigger property.

The biggest downside of overpaying your mortgage is that the money is locked away until you sell your home or remortgage.

This is why it’s important to have your emergency fund set aside first, and pay off any debts.

Matt Coulson, director of Heron Financial, suggests getting an offset mortgage as an alternative.

He said: “If you have substantial savings, or you benefit from earnings bonuses and commission on top of a regular income, you could benefit from using this extra cash to pay off your mortgage.

“An effective way of doing this would be to set up an offset account whereby any savings in your bank account are automatically offset against the balance owed on your mortgage and will reduce the term of your mortgage.”

Offset mortgages tend to have higher interest rates, but you do have the benefit of being able to access your money when you need it. When you do withdraw the money, it just increases your interest rate repayment.

Another downside is that there aren’t as many options available as traditional mortgages. You can do a comparison on sites like money.co.uk to see what’s available though.

Weighing up the difference

Once you’ve compared the figures, and the pros and cons, there’s one more thing to consider: your risk appetite.

Peter Fairweather, head of advice at Multiply AI, said: “We would suggest that more cautious investors look at repaying their mortgage and more adventurous investors look to invest. If you’re in the middle, then why not do a bit of both!”