Should we clear £20k of our £100k interest-only mortgage or invest it? DAVID HOLLINGWORTH replies
By DAVID HOLLINGWORTH FOR THIS IS MONEY
Updated:
Our fixed rate mortgage is about to end and is made up of two parts on the same deal, a repayment element and an interest-only element.
We have seven years left to run, with £200,000 to go on the repayment element and £100,000 on the interest-only element.
We are investing to pay off the interest-only part and have £20,000 in stock market investments that are working towards this.
Interest rates are now considerably higher than they were when we took out our current five-year fix and we are likely to end up going from a rate of 1.4 per cent to about 4 per cent.
How can we work out if we should continue with the borrowing at the same £200,000 repayment combined with £100,000 interest-only level and keep the £20,000 pot invested, or use the £20,000 to pay down a chunk of the interest-only loan and start from scratch again investing to pay off the remaining £80,000?
Mortgage help: Our weekly Navigate the Mortgage Maze column sees broker David Hollingworth answering your questions
David Hollingworth replies: There's two ways to structure a mortgage when it comes to how it will be repaid, on a capital and interest repayment basis or an interest-only basis.
The first sees the mortgage reduce each month, as each payment will cover not only interest but also an element of capital.
That will ultimately see the mortgage completely repaid over the mortgage term assuming all payments are made, so is the lower risk approach.
Interest-only does what the name implies, and the monthly payment only covers the interest charged on the mortgage.
That requires an alternative repayment strategy, such as a separate investment vehicle, to be in place to hopefully grow adequately to repay the balance by the end of the term.
This choice is often talked about as an either/or decision but, as you've done, it's possible to split the mortgage into separate elements and structure it on a part repayment, part interest only basis.
The flip side is the risk that the repayment vehicle will not grow adequately to meet the outstanding mortgage amount. That's why it's important to keep the repayment vehicle under regular review.
Below is a look at your options.
It is straightforward to understand how paying off the current £20,000 balance from the interest only balance will cut the monthly mortgage payment.
At a rate of 4 per cent that would reduce the monthly mortgage payment by just under £67 per month.
That may be attractive to cut the monthly commitment at a time when you will be seeing a sharp hike in interest rate.
However, it would be worth double checking the current balance. You will have made significant inroads into the mortgage at such a low rate over the last five years, so there may not be as big an increase in payment as you anticipate.
> Mortgage calculator: Compare repayment vs interest-only
Investing to pay off an interest-only mortgage is one thing but what you can't know is how the investment may perform over time to reach a conclusion.
I'm not an investment expert and you should seek specialist advice on the investment itself, bearing in mind that you could be liquidating the investment at a time when its value has been hit by the recent market turbulence.
If you sell up now and pay off the £20,000, you would also be starting over in terms of what may work as your repayment vehicle for the remaining £80,000 interest only mortgage.
Time in the market and the benefit of compounding are often cited as important to growth expectation. However, a bigger concern has to be the time remaining to reach the target and how much you need to contribute each month.
Specialist investment advice will help you understand whether you need to make a bigger commitment to hit the target. The ongoing interest rate environment will also shape your thinking about the right approach in future.
Simon Lambert of This is Money adds: As David mentions above, the problem those investing to clear a mortgage have is that they do not know what returns are likely to be.
If you make an over-ambitious presumption, then you could end up with a shortfall when it is time to clear the debt.
A good long-term average investment return would be 6 per cent a year after costs, but you could hit a poor run of market performance and get less.
Recent global stock market returns have been better than this, the MSCI World index has averaged 9.9 per cent annually since 2009, but this has been a period of strong returns and the next seven years could look very different.
This is Money's long-term saving and investing calculator shows that £20,000 invested over seven years at an average 6 per cent annual return would grow to £30,407.
That won't clear your debt. You would need to add regular monthly contributions of £607 to reach your £100,000 target in seven years.
If you paid down £20,000 and started again, over seven years at an average 6 per cent growth, you would need monthly contributions of £770 to hit the new £80,000 target.
This would be an extra £163 per month, showing the benefit of compounded returns on your existing £20,000 investments.
If you paid down £20,000 and moved £80,000 to a repayment loan, at 4 per cent over seven years, monthly payments would be £1,095.
The figures show that investing to clear the mortgage could pay off if you can get a higher return than the home loan rate - and ideally do this tax-free in a stocks and shares Isa.
On the flipside, paying down the debt gives certainty and investment returns aren't guaranteed. Stock markets can go down or sideways, as well as up.
> Mortgage finder: Check the best rates based on home value and loan size
It sounds like you understand the potential risk of interest-only and it's a good idea to review the approach at the point of deciding on a new deal.
Taking advice on the investment side will help you consider the repayment vehicle but think about the mortgage too.
From the mortgage perspective it will be important to think about the right type of deal.
Fixed rates remain the more popular with many borrowers, and the very keenest rates have been falling back below 4 per cent.
If reducing the monthly payment is a high priority you could also potentially consider lengthening the mortgage term.
This isn't ideal as, although it will reduce the monthly payment on the remortgage element of the mortgage, the total interest charge over time will escalate.
The increased interest could be managed by making overpayments as and when it's possible or trimming back the term again later. Overpaying will sound easier said than done now, but that could change over time.
You may also have the chance to reduce the reliance on the repayment vehicle when you review the mortgage, allowing you to shift more or all to repayment if you preferred, or if the vehicle is failing to keep pace.
Unfortunately, with several future unknowns you can't be 100 per cent sure of the right choice.
Much will depend on your attitude to risk and your confidence in the likely growth of your investment.
Keeping tabs on the vehicle is vital and considering whether that will be enough to reach the required amount in seven years should be the priority.
David Hollingworth is This is Money's mortgage expert and a broker at L&C Mortgages - one of Britain's leading specialists.
He is ready to answer your home loan questions, whether you are buying your first home, trying to remortgage amid the rates chaos or looking to plan further ahead.
If you would like to ask him a question about mortgages, email: [email protected] with the subject line: Mortgage help
Please include as many details as possible in your question in order for him to respond in-depth.
David will do his best to reply to your message in a forthcoming column, but he won't be able to answer everyone or correspond privately with readers. Nothing in his replies constitutes regulated financial advice. Published questions are sometimes edited for brevity or other reasons.
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