Should you pay off your mortgage early with excess cash? Any answer given to this question, without knowing the specifics of your mortgage, corresponding interest rate or term and personal financial circumstances, should only ever be read in terms of high level information. It is not a ‘one-size-fits-all’ answer. Always look for advice from your Financial Advisor before making definitive decisions on something that can significantly affect your long-term financial position.
Although there is quite a lot of crossover, to give as much fully fledged information as possible, we have split this answer into 2 parts – those on a tracker mortgage and those who are not.
As tracker mortgages are directly linked to ECB rates, the current mortgage interest rate is effectively zero* (plus a small margin) and has held this exceptionally low rate for a number of years so paying down your tracker mortgage should be the last item on your financial planning priority list as you may never again get a loan with such a low interest rate.
There are a number of items that should be given due consideration before paying down your mortgage early:
A tracker mortgage is, right now, the lowest interest rate based loan you may ever receive in your lifetime. The ‘cost of borrowing’ has been significantly reduced because of the unprecedented consecutively low ECB interest rates from which the tracker interest rate is based. So essentially, you should be looking to pay off whatever other loan or credit card or borrowings etc. that exist within your household before looking at the mortgage.
Do you possess a credit card? Interest rates on credit cards can be has high as 8/9/10% meaning the cost of your shopping could essentially be far higher than the cost of the products you buy if you are not keeping on top of your credit card repayments. Pay this card off and snip it – it is essentially one of the most expensive forms of payment that we have access to.
Have you a car loan, holiday loan or any other sort of borrowing that is forcing you make repayments on a monthly basis? The high likelihood is that all of these borrowings are at a far greater rate than your almost zero mortgage interest rate – so they should be paid down before your tracker mortgage.
Set the scene – it’s the middle of winter and you come home from work to realise the heating is not working. A quick drop-around from your local plumber tells you that your boiler has taken its last breath and it will be €3,000 to replace and install. Couple this with a Christmas list far beyond what your December pay packet can afford.
- Introducing – the ‘rainy-day’ fund!
It is an essential part of good financial planning practice to always have a sum of money simmering in your bank account for these types of unplanned emergencies. The recommendation would be 3 to 6 times your salary, depending on the salary level and on family circumstances. It needs to sit in your bank account so that you have easy access to the funds. Ultimately it is lazy money in terms of what it can yield for you in interest, but a necessary part of financial planning.
Are you maxing out the amount of money you can pay into your pension?
There are sizeable incentivised tax breaks available to those who pay into a pension:
- Income tax relief
- Tax free growth
- Tax free lump sum in retirement
It is an essential part of any financial planners playbook of recommendations to point out the benefits that can be attained by paying into a pension. Paying €100 into a pension every month will only cost you €60 if you are on the higher tax bracket – the government pays the other €40 i.e. you are given free money to enjoy in your retirement years.
If you have spare cash lying around, paying it into your pension would make more sense than paying off an almost 0% interest loan. If you’re part of an employers pension scheme, your decision to raise your pension contribution from e.g. 5% to 8% could result in your employer matching this increment.**
A large portion of the Irish workforce are not making enough use out of this significant tax incentive.
Invest that spare cash
A deeper conversation is required here but depending on your financial goals and the level of excess money in your household, a monthly investment or savings policy could prove to be much more beneficial than paying off your tracker mortgage early, over the long term.
If you have a pot of money you don’t need to touch for over 5 years (kid’s education, children’s allowance etc.), an investment should prove to be a more worthwhile home for your money over the medium to long term. Investing in a portfolio similar to 60% stocks and shares and 40% bonds, has a 96% guarantee of a return higher than deposits, at the end of a 5 year period. Your attitude to risk and comfort threshold in relation to risk is important in this discussion because the potential rate of return also depends on how much risk you are willing to take with your money.
The baseline of financial advice is centred around protection. Are you financially secure if anything were to happen to either you or your partner in the future? If either one of you were to get sick – have you taken steps to assist with the bills that will continue to come into your household, despite the fact that there may be only one income for a period of time? Are all of your significant debts covered?
Making sure you are have security in terms of your finances should the worst occur, is such an important factor to consider – for your entire life.
Standard Variable / Fixed Rate Mortgage
Mortgages that start out on anything other than tracker mortgages will more often than not begin with a fixed level of interest for a finite period of time and then move into either variable rates or a further fixed period of interest rates.
As above, there is a lot of cross-over in terms of what should or could be done with your excess cash before paying off either your tracker or fixed or variable rate mortgage. However there are some reasons why, in this scenario, it may be prudent to chip away at that mortgage to ensure it gets paid off earlier than the initial term set down.
Higher interest rates
Your mortgage interest rate is what’s really important here. An interest rate in excess of 4% or 5% would absolutely warrant early pay off because that sort of return in a savings or investment account is really the most that would be achieved for those people who find themselves with a ‘medium’ risk classification level. The majority of ‘investors’ don’t opt to take high risk unless they have a large diversified portfolio of investments which allows for higher risk assets. Even on the higher end of between 2% – 4%, it can still make sense to pay off the mortgage. But once again, this depends on your overall attitude to risk and current financial circumstances.
Low risk tolerance
For someone who is completely risk adverse and who does not want to invest at all, even in a lowest risk type fund, then paying off your mortgage can be sensible because leaving your money sitting in a deposit account is likely to earn (and continue to earn) you very little in the foreseeable future. (TradingEconomics.com) In actual fact it will lose its ‘real value’ by simply sitting in that account over the medium to long term i.e. if inflation rises and interest rates do not. The net effect of this would be that your money would be worth less to you in 5 to 10 years than it is now if those kind of low interest rates prevail into the medium or long term. So using that money to pay off your mortgage early would be an effective use of that excess cash.
Cost of borrowing
The overall cost of borrowing (i.e. the interest) can be reduced by paying down your mortgage in a shorter timeframe than initially set out. Paying off your capital earlier can also reduce down the loan to value ratio over time and may allow for lower interest rates in the foreseeable future.
Be careful however in relation to additional repayments or changes to mortgage repayments – they could incur a penalty from your mortgage provider, especially if you are on a fixed rate mortgage.
Taking all of the above into consideration, the previous points in relation to payments into your pension, making sure you have a rainy day fund and having correct protection in place, is also very important in this scenario.
It is important to also consider any immediate or short term savings requirements? For e.g. are you planning on buying a second home and need to save for a deposit? All these life changes and financial requirements must be taken into consideration before making the decision to make additional payments to your mortgage.
Final thoughts on paying your mortgage off early
Specialists, be they mortgage, investment or protection experts will tell you what’s best to do in relation to their line business and can be very convincing in terms of making you think a particular road taken is the one that makes the most sense. Sitting above all that excellent individualistic advice should be someone you trust to guide you on the consequences of certain decisions made. For example, it may be an effective use of your excess income to pay off your mortgage early but what if you had no ‘rainy day’ fund for an emergency? What if you haven’t paid a sufficient sum into you pension (with all its tax benefits) and found yourself with insufficient funds to support the next 20 to 30 years of your retired life? What if you had kids and you or your spouse got very sick? If you have a Serious Illness policy in place to ease a potential future financial burden, you could save your family during a really challenging time in your lives.
A trustworthy advisor should lay out all these options for you in an easy-to-understand manner. If you’d like to speak to someone about your financial planning, please contact a member of the Trust Matters team today. Email firstname.lastname@example.org or call 01 563 4300.
*Source – RTE Business March 12th 2019
**An employer may not always match your pension contribution increment. Your employment contract will outline their obligations. You can also speak to someone in your HR department for more information.