Why paying off your mortgage early will negatively impact your net worth
There is a growing trend of setting goals to target financial independence and retire early. It also feels like the first rule of achieving this is to pay off your mortgage. Well, if you pay off your mortgage quicker you can have freedom and control over how you work and your life. Those that pursue financial independence or financial freedom often site this as one thing to focus on.
I must agree that there is something quite satisfying about being mortgage free and not having to worry about how to pay the next mortgage bill. Even if this satisfaction cannot be quantified, it is worth acknowledging.
As someone that has worked in the investment industry for over a decade, it still leaves me thinking if this is really the most efficient outcome for your net worth over time.
Case for paying off mortgage early
The arguments sited for early repayment of mortgage include
Financial freedom and not worrying about a roof over your head
Having more income to do what you want, when you want
Saving on interest
Having spare cash to invest and grow wealth
I’m sure there are many more arguments to support early repayment of mortgage especially when to all intents and purposes it is a debt!
What’s the alternative then? Pension? Hang on; even the Bank of England’s Chief Economist said that he didn’t understand pensions . When most people are told about pensions they switch off. Let me try to build a case for pensions that will change your mind.
Case for a pension
Pension schemes these days are relatively simpler than they use to be. All you have to do is contribute a proportion of your salary, your employer also contributes and both contributions are not taxed. All contributions are invested and you have a choice of what to spend your pot of money on when you come to retire, which is as early as age 55. In summary the benefits are
When you contribute your employer contributes too
The contributions are not taxed
If invested in stocks for the long term then the rate at which your portfolio grows is expected to be higher than your mortgage rate
There we have it. Very strong cases for paying off mortgage and also for pension. To bring this to light a bit more let’s use some simple examples. Let’s split our readers into two teams.
Team Payoff Mortgage Early, and
Team Invest in a Pension
Team Payoff Mortgage Early
John is tempted by both options but not quite sure which to choose. He’s age 30 year and earns £40,000 a year and plans to retire at 55.
Mortgage outstanding - £200,000
Mortgage rate - 3.00% p.a.
Time to clear mortgage - 25 Years
Monthly Mortgage - £948
John decides he’ll pay his mortgage off earlier so that he is mortgage free sooner. So his actions are set out below.
Overpays by £150 a month
Finishes paying off his mortgage 4 years and 9 months earlier. He also saves £17,465 on interest and will feel extremely smug at the end.
After early repayment, he now has £1,098 of cash spare every month to invest.
If this cash is invested with expected growth of 6% per year then over the four years and nine months before he gets to age 55 he could build up an investment of £74,000 and is mortgage free
Team Invest in a Pension
Actually if John listens to the pointy head pension guys and invests that £150 in his pension every month, what’s the outcome?
John’s pension contribution is £150 a month
The tax man gives him his tax money back at 25% as contributions to pensions are not impacted by tax. The amount he gets back is £37.50
His employer also contributes 2% of his salary which is £67.00
Total paid into pension every month £254.50.
This is invested at an expected growth rate of 6% a year over 25 years. At age 55, John expects to have a pension pot of £184,000 and is mortgage free too!
Bringing it all together
As we can see, the numbers show clearly that saving towards your pension works out much better than paying down your mortgage!
|Team Pay off||Team Invest|
|Mortgage repayment period||21 years and 3 months||25 years|
|Savings on mortgage Interest||£17,465||-|
|Expected portfolio growth rate||6%||6%|
|Contribution to net worth at age 55||£74,000||£184,000|
However, finances are not usually this straightforward as our emotional biases and behavioural finance play a big part in our financial decisions. Some people absolutely hate debt, any kind of debt and would feel much better paying down the mortgage. Beside some would argue that the expected growth of your pensions is not guaranteed so best to pay off the mortgage.
Good luck with your journey to financial freedom whichever route you choose. However it is important to bear in mind the powerful wealth generative potential of a pension and consider putting one in place while you are still young as your future self will thank you for it!
So here are the steps I would suggest you consider taking
Contribute the maximum you can into your pension fund and invest for the long term
If there are any funds left then overpay your mortgage. Or look for a side hustle to generate more cash to help you over pay your mortgage
Let us know your thoughts in the comments section and please do share with someone that may find this useful.