When investing beats paying off your mortgage

The choice between investing and paying off your mortgage used to be a no-brainer: at a time of steady stock market returns and cheap debt, in most circumstances it made financial sense to invest first and clear your mortgage later. But now that interest rates are higher, if you are approaching the end of a fixed-rate deal and face a rise in mortgage costs, paying down some of the debt sounds more sensible.

However, over the long term, investing first is still likely to be more profitable in most cases – unless your mortgage rate is consistently higher than your investment returns and you redirect monthly mortgage payments to your investment account after the debt is cleared. In the table, available to download below, research by investment platform Interactive Investor runs the numbers for a range of different scenarios to help you figure what might be the best option for your circumstances.

Investing vs paying off debt

Investing broadly remains more profitable than paying off debt. With a 6 per cent average mortgage rate, overpaying a 20-year £200,000 mortgage by £200 a month would enable you to pay it off four years earlier and save about £33,600 in interest owed. But if you invest £200 a month into an individual savings account (Isa) for 16 years and achieve a 4 per cent net rate of return, you will make around £53,700 - or £20,100 more.

As of 1 February, average residential mortgage rates stood at 5.44 per cent for two-year fixed-rate deals and 5.2 per cent for five-year deals, according to Moneyfacts. But the Bank of England base rate might have peaked or be about to do so and, while interest rates will not go back to their 2021 levels for a while, it seems unlikely that they will remain this high for the next 16 years.

At the same time, while 2022 was a difficult year for returns and 2023 might not be much better, in the long term a 4 per cent average annual return makes for an achievable target. But remember that the gross return rate will need to be higher to account for fees.

If you invest the money in a pension rather than an Isa, the tax relief will give a further boost to your investments, and the difference between investing and paying off debt becomes even more pronounced. But the projections in the table do not account for how you take money out: you may owe income tax on what you take out of a pension, and capital gains tax and dividend tax on investments held in a general investment account. 

Invest now or later

While investing usually delivers better results than paying off debt, it becomes more complicated when considering whether to overpay your mortgage first and invest later. In this situation, your mortgage rate and investment strategy make a difference.

In the example above, after clearing your mortgage four years early you could invest the equivalent amount - which for a £200,000 mortgage over 20 years at a 6 per cent rate would be £1,633 a month - in an Isa for four years. If your investments return 4 per cent, this will make about £84,900 – or £11,500 more than investing £200 a month for 20 years. But if your mortgage rate is 4 per cent and your investments return 6 per cent, clearing your mortgage first and investing later would make £16,000 less.

Alice Guy, personal finance editor at Interactive Investor, explains: “In general, if investment growth is higher than interest rates then we’ll be better off paying into our pension first, giving our investments longer to grow. In contrast, if interest rates are higher than investment growth then we could be better off paying down our mortgage first.”

One thing to consider in this scenario is whether you will be able to contribute such a big annual figure to your pension after you have paid off your mortgage. If by that time you have started accessing your pension pot, the money purchase annual allowance (MPAA) might be triggered, meaning that you cannot contribute more than £4,000 a year to pensions.

As the table shows, the figures swing even more violently one way or the other if you contribute a lump sum to your mortgage or invest it. This option can look especially attractive in the current environment and adding equity to your mortgage will lower your loan-to-value (LTV) ratio, potentially enabling you to have a lower rate on your mortgage. But there are also a few downsides.

Consider where the lump sum is coming from. If you do not already hold it in cash you might have to sell some investments in order to raise the money. If the investments are held outside an Isa, you may have to pay capital gains tax on any gains you make above the annual allowance, which falls from £12,300 to £6,000 in April. And if you are sitting on losses following the recent market downturn you should avoid crystallising them.

Dawn Mealing, head of advice policy and development at Fidelity International, adds that selling investments to pay off a mortgage can be especially problematic if you were drawing income from those investments. You would either need to reduce the amount of income you take or, with a smaller portfolio to draw from, run the risk of eroding that capital. As we discussed in ‘How to use your pension tax-free lump sum’ (IC, 20 January 2023), using it is an option, but if you delay taking your tax-free lump sum you are likely to be able to access a bigger one at a later date. 

However, if you have a sizable cash sum at your disposal you will not be able to contribute it to an Isa or pension in one go because of their respective annual contribution allowances. You will initially need to invest part of it in a general investment account, and invest chunks of it each year into Isas and/or pensions.

Can your returns keep up?

But paying off your mortgage first might be a safer bet. Becoming debt-free can be a big relief, and Mealing says that doing this can be helpful if you intend to retire early or reduce your hours, meaning that you have a lower or less regular income.

Your time horizon also matters. Jason Hollands, managing director at Evelyn Partners, argues that if, for example, you expect to retire within 10 years, in the short term “it may be wiser to focus on paying down the loan”. While over the past 20 years the FTSE All-Share and MSCI AC World indices have generated annualised returns of 7.1 per cent and 10.3 per cent, respectively, higher interest rates create a challenging environment for equities and these indices may not deliver the same level of returns in future.

“For those with a longer-term horizon, a combination of capital repayments and investments can still make sense,” adds Hollands. 

With the best mortgage deals currently hovering around the 4 per cent mark and hopes for a decrease in interest rates in the next year or two, an annualised net return of 5 per cent could keep your investments in line with or ahead of your mortgage, especially in the long term.

A strategy targeting returns of 5 per cent a year or more should be well-diversified and include exposure to funds that target companies with sustainable dividends. “Share prices can be erratic over the short term, but well-covered dividends offer a degree of predictability,” says Hollands.

Capital preservation is also important to make the most of compounding. After bonds sharply depreciated last year, one way of achieving a 5 per cent annual rate of return without excessive drops might be fixed income. Mike Hollings, partner at Shard Capital, says that a nominal 5 per cent annualised rate of return with a 20-year time horizon should be achievable “without taking excessive risks”.

Starting from the relevant risk-free rate – in our case, the yield on 20-year gilts which is currently 4 per cent – Hollings suggests allocating 25 per cent of a portfolio to short-dated gilts to use as opportunistic cash. You could allocate 50 per cent to investment-grade bonds to provide the bulk of income generation while protecting capital. And the remaining 25 per cent could be put into equity-type investments that focus on yield but have the potential for capital growth, such as infrastructure investment trusts and stocks that pay attractive dividends. This should generate a yield of roughly 5.1 per cent. 

If the sole purpose of the investments is to beat your mortgage rate, you do not need to account for inflation. But to preserve or grow your capital in real terms, you will need to target higher returns and will likely need a more aggressive investment strategy.