Should I pay off my mortgage?
Every mortgage borrower dreams of the day they no longer have to fork out those monthly payments to their lender, being able to spend the money how they wish while owning their home outright. But if you do have a lump sum, is it always best to pay off all or even part of your mortgage early?
What is the main reason to pay off my mortgage early?
The biggest reason to pay off your mortgage early is that often it will leave you better off in the long run.
Standard financial advice is that if you have debts (such as mortgages), the best thing to do with your savings is pay off those debts.
With rare exceptions, mortgage rates are higher than savings rates, and so if you have a lump sum in a savings account, you will receive less in interest each month than you would save from paying off that amount of mortgage (see question below on “How much can I save from paying off the mortgage?”).
Being mortgage-free can make it easier to downsize in other ways – such as going part time – and usually makes it cheaper and easier to buy and sell your home. Generally, a smaller mortgage gives you greater freedom and security.
What is the biggest reason not to pay off my mortgage early?
In short: opportunity cost. The money in your savings account is yours to do what you like with, but once you have paid off the mortgage that is it. If you pay off your mortgage early, you cannot then use the money for anything else, which could be alternative investments (such as buying another property), splurging on luxuries like a new car, or coping with costs such as mending your roof or paying school fees.
Once you have paid off the mortgage, it will be difficult to get the money back again, unless you go through the hassle and expense of taking out a new mortgage, which might be difficult since lenders have been tightening their conditions. If your household income has gone down, you simply might not be able to borrow as much. And whereas once there was tax relief on mortgage interest this has not been the case for some time.
What do I need to consider when deciding to pay off some or all of my mortgage?
- What is the interest rate on your mortgage, and how does it compare to the interest you can get on a savings account? There is also the potential you pay tax on those savings.
- Are there any penalties for repaying the mortgage early? If you are on a fixed rate or discounted mortgage, there might be significant costs for paying it off early
- Are you expecting any windfalls, such as selling a business, or inheritance? If you are expecting a large amount in the near future, there is probably less downside to paying off the mortgage
- Do you have alternative investments that you want to make – e.g. buying another property, or building up a business?
- How much money do you need for a rainy day fund? We suggest a minimum of three months outgoings, but six months is safer
- What costs are you expecting? If you have years of school fees ahead of you, you might want to keep a large ring-fenced sum aside so you know you can to cover them, rather than paying off the mortgage. An off set mortgage might fit the bill in this instance.
- Are you expecting a decrease in income? In which case, you might want to keep extra savings to tide you over.
How do I work out how much money I will save by paying off the mortgage?
First, you need to find out the monthly interest you are paying on your mortgage. Unless you are on an interest-only mortgage, this is not the same as your monthly mortgage payments, as they will include not just interest but capital repayments also. Either ask your lender what your monthly interest payment is, or calculate it from the interest rate that you are paying. They find out what interest you are receiving on your savings, and how much tax you are paying on that (the first £1000 of interest is tax-free for lower rate tax payers, while top rate taxpayers pay 45% tax on all interest received).
Then it is quite simple – if your monthly mortgage payment is greater than the interest you are receiving after tax, you will be better off paying off your mortgage. As an example: say you have a £100,000 mortgage at 3%, and £100,000 in a savings account earning 0.5%, and you are a lower rate tax payer. Then the mortgage interest payments are £3000 a year, but the interest you receive is £500 a year (below the £1000 limit, so you pay no tax on the interest). If you use your savings to pay off the mortgage you will be £2,500 a year – or about £200 a month – better off.
Will I be better off using the money to buy something else?
It is possible (but unusual) that you can be confident of earning more from using your savings in some other way than paying off the mortgage. For example, some pensioner bonds pay higher than mortgage rates. You might persuade yourself that a second property or stocks and shares will grow in value each year more than the interest rate on your mortgage, but they come with a risk.
How do I find out about any penalties?
If you are on a special mortgage deal, such as discounted or fixed rate, then there are likely to be penalties for paying the mortgage off early. Simply ask your lender if there are any penalties, and if so how much are they. Normally, the penalties decrease towards the end of a fixed rate or discounted period; also you can often pay off a certain amount – such as 10% – a year without incurring penalties. If the penalties are small, it might still be worth paying off the mortgage early.
Do I have to pay off the whole mortgage?
No – often you might just want to make a capital repayment that only partially pays off the mortgage. All the same arguments about being better off doing this still apply. Even if you have enough money to pay off your whole mortgage, you should still try to keep some aside as a rainy day fund. So in the example that you had a £100,000 mortgage and £100,000 savings, you may want to just pay off £75,000 of the mortgage and keep £25,000 savings.
Will paying off my mortgage affect my ability to move home?
If you are moving to a similar priced, or cheaper, property where you will also not need a mortgage, then it makes it easier and cheaper – you will not have to deal with the mortgage company throughout the process, pay their mortgage fees, or use surveyors or conveyancers approved by them. But if you have a portable mortgage, and would need the mortgage on a new more expensive home, then it might be best just to stick with the mortgage and use your savings to increase the deposit you are paying on the new home.
Should I accept my parents offer to pay off my mortgage and for me to pay them instead?
That’s nice of them! But it depends on many things – not least what interest they want to charge and how well you get on with them.
Generally loans from parents are seen as “soft loans”, and they are a lot more flexible than a mortgage lender (we have yet to come across parents who charge earlier redemption penalties!).
If they charge less interest than the mortgage company, then clearly you will be better off.
It also can help to “keep the money in the family” – you can often reach a deal where both sides are better off, because your parents will earn more lending to you than they would saving with a bank. So, for example, if you are paying 3% interest to the mortgage company, and they are earning just 1% interest, then if they lend to you at 2%, both you and your parents would be better off. But of course there are potential risks so you both might want to get independent financial advice.