Interest rates are the highest they’ve been for 15 years, the average two-year fixed mortgage is above 6% and investment markets have had a bumpy ride the last two years. So is it best to save, invest or pay off your mortgage?
In this blog, I’m going to look at the factors that you should think about when it comes to this decision.
Factor 1 - Financials
Let’s say you’re in the fortunate position where you have an extra £250 per month that you can decide what to do with. Let's look at each option:
At the time of writing, the best rates for instant access savings accounts are around 5%. If you can lock your money away for longer and meet the minimum deposit then NS&I are currently offering a one- year fixed rate account at 6.2%. However, in this example, we’re looking at regularly saving so we’ll use 5.2%.
If you were to put £250 per month into a savings account with 5.2% interest then after 20 years you would have £104,174 saved.
According to Rightmove as of 30th August 2023, the average 2-year fixed rate mortgage at a 75% loan-to-value is 6.17%. So, let’s say you had a £200,000 mortgage on a 20-year term. Without overpaying your mortgage your monthly payment would be £1,453 per month. However, by paying an additional £250 a month to your mortgage (so a payment of £1,703) you could clear your mortgage in 15 years and 1 month instead of the original 20 year term.
Once you’re mortgage free you have this additional cash month to month. If we use the 5.2% savings rate from earlier and your previous monthly payment of £1,703 is put towards this savings account for the remaining term (4 years and 11 months) then you would have £114,348 saved.
Predicting future returns for investing becomes a lot trickier and unlike fixed mortgages or savings, we can’t guarantee any growth rates when it comes to the stock market.
The MSCI World is a global equity index, tracking stocks from 23 developed countries has had an average growth rate of just under 11% for the past 53 years but when we look at the past performance we can see no years are average.
Source: MSCI World Index (USD), annual performance 1970-2022
This past performance illustrates the main trade-off when it comes to paying off a mortgage or saving in a cash account vs. investing. With investing, you take on the risk that markets will underperform cash or even lose value in certain months and years. However, we can reduce this risk by looking at a longer timeframe
The probability that your investments will have a positive return increases the longer you hold your investment. Looking at data from developed equity markets between 1971 and 2022, your chances of suffering a loss go down over time. During this period, you would not have had negative growth as long as you held your investment for 15 years.
Source: Macrobond; MSCI World Equity Mid and MSCI Large Cap Total Return in GBP, 1 January 1972- July 2022
So the longer you hold your investment, the better chance you have of positive growth and one that is closer to the long-term average. As we’re comparing against a mortgage term, which in this case is 20 years then we can have more certainty over longer term stock market performance.
As we all know, past performance is no indication of what future returns will be but to give us a predicted growth rate, let’s look at what the forecasts say.
Vanguard forecast global equities (minus the UK) to grow between 5.8 and 7.8% per annum over the next 10 years whereas back in September 2022 forecasts from other companies tended to be higher.
Let's compare an average growth rate of 8% to our mortgage and savings example.
If you were to put £250 per month into an investment account with an average 8% growth rate then after 20 years you would have £148,236.
This outperforms the mortgage option by £33,888 and the savings option by £44,062.
Factor 2 - Certainty
However, so far, we’ve only looked at the financial side of this decision and not the emotional side. With paying down a mortgage or contributing to a savings account, you know you’re interest rate year to year. If you remortgage at 6.17%, you might much rather know you are paying this down at that set rate than invest your extra cash where year to year we don’t know what the return is.
Some people prefer this certainty of knowing what they’re saving by paying down their mortgage, this peace of mind can outweigh a potentially greater return given by the stock market.
This may become more of a factor if you’re a few years of paying your mortgage and you want to pay this off as quickly as possible or your time horizon for investing is shorter and thus provides more uncertainty.
Factor 3 - Accessibility
By paying down your mortgage the money is effectively tied up as equity in your house. If you need to access your money for whatever reason it is a lot more difficult to do this when it is tied up in your house than it would be to withdraw from a savings account or to even sell your investments.
Holding a portion of your money in a savings account is always sensible for the short term. As I showed earlier, when it comes to investing the shorter the timeframe, the greater the chance of you losing money. Personally, I like to keep 6 months of my living expenses in a savings account in case I need to access this for an emergency however for some people this might be more, it might be less.
As you might be able to tell there isn’t a perfect answer. What you do very much depends on your personal circumstances and approach to money.
The trade-off between investing, saving into cash and paying down a mortgage is different for each person.
The certainty of paying down a mortgage can be attractive to those who don’t want the ups and downs of an investment and if this sounds like you, perhaps you should allocate your extra cash towards paying down your mortgage.
If you do have tolerance for the ups and downs of the stock market and you can invest for the longer term then investing your extra cash for the hope of a greater growth rate would be a preferred option.
It’s important to remember, you don’t have to go all in on one strategy. You can do a combination of the options to whatever degree best suits you.
Equally, you don’t have to stick to one option permanently. Current savings and mortgage rates are likely to change in the future and if the trade-off between the certainty of a mortgage repayment or savings account and the uncertainty of an investment gets even closer then it may not be worth it for you to take that investment risk.
If the gap widens then this may be enough reason for you for you to start investing your spare cash.
As with all personal finance decisions, there is no right answer.