Hiya internet! Mr. Frugalwoods here today! While Mrs. FW is our chief writer, comedian, hound ear scratcher, and yoga practitioner… I occasionally cobble together something mildly intelligible and toss it in her general direction for her editorial prowess. Don’t worry, she approved this post before I published it.

Here at Frugalwoods HQ, we love getting questions from readers:

  • Does Frugal Hound like treats? Eh, sometimes, unless the treat is anchovies in which case YES, YUM!
  • When will Frugal Hound debut her own line of fall fashion scarves? R&D is still working on the “Live Squirrel Scarf” concept…
  • Greetings to you on an exalted by god meeting for mutual fortunate benefit. My sister, queen of Malawi, needs immediate helping for to bring repatriate gold to US shores…  Uh, yeah. Frugal Hound can answer that one.

We also receive interesting financial queries that can’t be answered by a photo of a greyhound with a pumpkin on her head (although I included one in this post just for good measure). On Friday, Mrs. FW solicited your feedback on what you’d like to read here on Frugalwoods and many of you commented or emailed us with suggestions–thank you! We hope to get to all of your ideas before too long. One request in particular piqued our interest and prompted this post…

Reader Tara emailed over the weekend to ask:

I am really risk adverse and scared of investing so what are your views on repaying your mortgage off quicker with your frugal savings versus actual investing? Or tips to begin investing with? I live in the UK so not sure same regulations apply.

Investing?  Mortgages? Jollye olde Englande? (or Scotland, Wales, N. Ireland)? This sounds like a job for the Frugalwoods reader diaspora!

Don’t care what I have to say? (Frugal Hound, who is standing next to my chair begging to be scratched, would agree with you)… then, skip right to the end and give your advice to Tara. Want to know what a US-based bearded blogger has to say about investing vs. mortgage payoff in Great Britain? Read on, brave blog denizen!

Frugal Hound begging for scratches
Frugal Hound begging for scratches at the Frugalwoods HQ table

Differences between US and UK Mortgages

We don’t know the particulars of Tara’s situation, so we’ll need to talk in generalities. Which is actually more fun, since I got to research common UK mortgage structure on a Sunday afternoon! Yes, I’m an odd duck.

From my admittedly limited research into UK mortgages, there appear to be several major differences vs. typical American mortgage loans:

  • The concept of a 15 or 30-year fixed rate mortgage is foreign. When a UK lender talks about a “Fixed Rate” they are referring to only the first few years of the loan. It appears that a 2-year or 5-year fix is normal, with a variable rate after that point.
  • Mortgage interest is not tax-deductible in the UK, whereas it is in the US.
  • Prepayment penalties are common, especially for fixed rate mortgages. These are usually a percentage of the amount paid early multiplied by the amount of time remaining on the fixed period. Take a look at this HSBC explainer for an example:

An ERC (Early Repayment Charge) will also apply where the customer repays, by any other method, the whole or part of their mortgage, over and above their standard monthly payment, during the fixed or discount rate period. The ERC will be 1% of the amount overpaid or repaid early multiplied by the number of years remaining of the fixed or discount rate period, reducing daily.

For example: A customer paying off their full mortgage of GBP 100,000, who has 18 months (547 days) remaining on their fixed rate period. The ERC would be: GBP 100,000 x 1% divided by 365 x 547 days = GBP 1,498.63  (source: HSBC fee listing)

Mortgage Payoff vs. Investing For The Risk-Averse

While many would sternly tell Tara to invest, invest, invest… I’m a firm believer that the best path to financial success is via a strategy that’s sustainable and comfortable for you. Tara says she is risk-averse (as are many people) and I doubt some dude on the internet (moi!) is going to convince her otherwise.

For risk-averse investors, I highly recommend low-fee index funds. You really only need two: a stock index fund and a bond index fund. The stock fund will provide the most growth over the long term, but will also be the most volatile. The bond fund won’t grow as fast during the good years, but also won’t drop as precipitously in the bad years.

Hello! Quick break from mortgages for a greyhound photo!
Hello! Quick break from mortgages for a greyhound photo!

The percentage of your portfolio kept in stocks vs. bonds is individual to each person and situation. That being said, here are some general guidelines:

  • The younger you are, the more stocks you should own. The old yardstick is “120 minus your age” in stocks. By that metric, a 30-year-old should own 10% bonds, while a 60-year-old should hold 40% bonds.
  • The more risk-averse you are, the more bonds you should hold. If you’re prone to panic (and be honest, there’s no shame in knowing yourself), you should hold more bonds than average. It’s much better to be 30 years old with 50% in bonds and not sell during a recession than to hold 10% in bonds and panic sell every time the market tumbles.
  • Some people consider bonds overpriced in today’s interest rate environment. If you buy this thesis, then you might want to hold fewer bonds.
  • In the US, bonds are not very tax efficient since the interest from a bond is taxed at your normal income rate. This means that holding bonds in a tax-advantaged account (like a 401K or an IRA) is a good idea. Similarly in the UK, bond interest is taxed as normal income; thus, holding bonds inside an ISA is a good idea.

For the very risk-averse, I think an acceptable strategy is to consider mortgage pre-payment as a portion of a “low risk,” or bond section, of an investment portfolio.

Time for a hypothetical! Let’s say you’re a 40-year-old risk-averse doctor named Martin, living in Port Isaac, Cornwall. You’ve decided to invest very conservatively, putting 60% of your funds in a stock index and 40% in bonds, or other low-risk investments. After expenses, you have £1,000 to invest per month. Your allocations could be as follows:

  • £600 to a low-fee index fund of stocks.
  • £100 to a low-fee bond index fund.
  • £300 to prepay the mortgage on your delightful seaside stone house.

Using a framework like this makes it apparent that paying off a mortgage is a form of low-risk investing. Just as you shouldn’t have a retirement portfolio consisting solely of bonds, you probably shouldn’t put 100% of your investable cash towards paying off your mortgage.

Frugal Hound in vermillion fall leaves
Frugal Hound in vermillion fall leaves

You’ll notice that I didn’t completely replace the bond allocation with mortgage repayment. Why? One of the great things about holding a low-growth, low-volatility investment is the ability to re-balance. The premise of re-balancing is that every year, you analyze the gains and losses in your portfolio and move money around in order to return to the percentage split you originally decided upon. When stocks are high, this means you’ll be selling stock and buying more bonds. When stocks are low, you’ll sell bonds to buy stock. This natural re-balancing will help lock in gains and give you “dry powder” to use during a stock downturn.

Since it’s tough to utilize an illiquid asset like your house as part of a re-balancing strategy, it makes sense to keep some money invested in bonds even while pursuing a mortgage pay-down.

Wrapping Up

Many thanks to Tara for writing in with such a great question! I had no idea UK mortgages were so different from US mortgages, and it was a fascinating learning experience!

OK readers, your turn: what advice would you give to Tara?

  • What do you recommend to risk-averse friends who want to pay off their mortgages?
  • Are you a UK investor? What index funds do you use?

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  1. I would have thought the answer to this question is largely dependent on the size of the outstanding mortgage, the interest rate payable and Tara’s plans for the next few years. If she’s a victim of negative equity (owing more on her mortgage than the property is worth) then she cannot sell the property without realising a loss. However, UK property prices are increasing in most areas of the country at the moment so that would help pay off the mortgage. Having said that, property prices are all relative if you’re moving from one to another (it’s debatable whether you could call your home an investment at all) so unless she is down-sizing, the next property she buys will be more expensive than the current one, resulting in even *more* debt. As in the US, UK interest rates look set to remain low in the near-term, but they have been at historic lows for the past 5 years and the situation is not sustainable long-term.

    As a result, I think it’s more complex than “should I invest or pay off my mortgage?” but common sense tells you that if Tara is extremely risk-averse then the worry of investing in an already frothy stock market which is at all-time highs (despite lower productivity and stagnation in Europe), she won’t sleep well if her money is invested in stocks. Peace of mind is extremely valuable and should not be ignored.

    1. Peace of mind is downright invaluable! 🙂 Thanks for the intel on UK interest rate movement. I knew folks would be able to fill in the blanks!

  2. Based on the news, The Bank of England is being warned about the risks to the mortgage market as it considers proposals to toughen rules limiting the borrowing of Britain’s big banks. Thus, I think there would be leverage ratio of 3.4 per cent, above the current 3 per cent minimum. 🙁

  3. I haven’t got a clue about her mortgage, but I would suggest that she get a beautiful, soulful-eyed greyhound. It would make her feel better about her financial situation in general. 🙂 P.S. You and Mrs. FW make an amazing comedy team! Thanks for the LOL’s! 😀

    1. HAHAHA. Yes, we often joke that Step 1 to solving any problem is to go give Frugal Hound some scratches. It always makes things seem more manageable and brings problems into perspective.

      Thanks for the kind comedy praise! Our jokes are terrible, but we think each other is funny so I suppose that’s what matters.

  4. I tend to feel that paying off debt (even a mortgage) is almost always a good idea. On the other hand, I would never sacrifice our investing plan to prepay more on our home. I would do a little of both!

    1. Definitely! I’m a fan of the mix, and a big believer that mortgage payoff can fit into a broader investment plan.

  5. I am in the “pay off debt” camp whenever it’s possible. Here, I think having no risk and owning your home outright would be an amazing feeling and place to be in. Then, there is time for investing.

    1. It would be amazing! While we’re keeping a mortgage on our current house (soon to be rental), we want to own our future homestead free and clear.

  6. I’m extremely risk averse, so I’ve been throwing all of my money at my mortgage, which so many bloggers would advise not to do. Owning my home free and clear is more important to me right now. I’ll become an investing rock star after that is paid off. 🙂

    1. You are already ahead of 90% of the population by saving that money instead of spending it on consumer goods… so I say be proud of it! How much more do you have to go?

      1. We are on a variable income so it’s tough to say exactly, but if all goes as planned, it shouldn’t take more than 2 more years. I’m hoping it will be only more year at the most. We shall see! It’s a great feeling either way. I’m definitely going to be blogging about it.

    1. It really is a weight, isn’t it? I don’t like to sit down and consider just what we owe to the bank for our home… but it is a staggering amount!

  7. Looking at the numbers, unless your mortgage has a really high interest rate, it’s generally better to invest. I really want to pay off our house, so we do both, meaning hit our investing goals then put extra toward our mortgage. If it wasn’t a home she would keep long term, I wouldn’t try to pay it off quicker. If it was, I’ve never heard anyone who owns a home free and clear complain that they wished they hadn’t paid it off. It must be a really good feeling.

    1. Good point about folks who already are mortgage free. I read way too much personal finance stuff online, and I’ve never seen anyone say they wish they still had a mortgage 🙂 !

  8. Depending on the interest rate of the mortgage and years left, if it’s high then I’d likely focus more of my available funds in investments and perhaps pre-pay the loan a bit. The reader needs to respect how they feel though but don’t let fear stand in the way of them gaining knowledge on investments and start with the tried and true of Index funds and ETF’s.

    1. It’s such a fine line between respecting one’s own natural inclinations but also pushing yourself to improve and overcome personal biases. Education is a great idea for overcoming a fear of investing, I wish I had thought of including that. Thanks!

  9. I think you gave a great answer.

    We’ve decided to pay down our mortgage, but I realize that that’s not the fastest way to reach financial independence and there are downsides to putting all your eggs in one basket. So, it’s not for everyone.

    1. Thanks! Being comfortable with your own decisions is a key to happiness, so I definitely understand your choice.

  10. I always weigh the cost benefit analysis of a client’s dollar, so if I think they can earn more investing their money over the long run than paying down a mortgage, I will advise them to invest. Most of my client’s now have mortgages that are in the 4% range. I believe that a conservative 60/40 asset allocation will earn 6-8% over the next 10 years, which means that my clients should have a 2-4% arbitrage on their money. I am not sure about UK rules but there are tax benefits for US clients on mortgage interest and well as their investments depending on whether or not they invest in a retirement account or not.

    1. Thanks Shannon! The math certainly points to investing over paying off mortgage debt with the low interest rates of today, that’s for sure! Figuring out a personal comfort level for implementing that strategy is something I’m still figuring out.

  11. I would give Tara the kind of Dave Ramsey advice that we have been following to get out of debt:
    Do you have other debts besides the mortgage? If so, pay them off to the exclusion of investing (apart from retirement savings through work).
    If the mortgage is your only debt, pay it off as aggressively as you can while investing 15% of your gross income (minus any automatic deductions your workplace might be making for your retirement).
    Mr. Frugalwoods, I really appreciate your mini-investment tutorial. Tara is not the only one who will benefit from it. I have a workplace pension plan, and I have not bothered to learn about investments over the years. I want to start though, and I’ll consider your advice here as lesson #1. We are within a year of the “debt-free-except-for-the-mortgage” stage of debt-reduction, and we’ll be putting Ramsey’s 15% advice into action at that time. This is good preparation. Thanks!

    1. Hey, so glad it was helpful!

      Looks like the Ramsey style also advocates a mix of investing and mortgage payoff, albeit making sure the investments are funded to a minimum amount before putting money towards the mortgage. Seems reasonable to me!

  12. Wow I was not expecting a) such a lovely FW post and b) such a great response from all you dear readers. I am some what overwhelmed. My mortgage is my only debt and we are on a fixed rate until 2018 currently at 3% and we own 45% of the property so no negative equity. Apart from being risk averse we live in the most expensive part of UK so house prices will increase at a faster rate where we live now, than they will in the area we intend to move to. Eventually in 5 years time we want to be mortgage free/small mortgage and buy a property with a holiday rental with it for additional income. Once again thanks for this great post and all the great advice I think I will look into some less risky bond investments once I have made a dent in my mortgage debt. Cheers Guys!

    1. Awww, thanks to you for posing a great topic of discussion!

      That seems like an awesome interest rate, good job on getting something that low!

    2. With a rate that low, I wouldn’t prepay, or certainly not that fast. I’d make sure I was taking full advantage of any tax-sheltered investment vehicles first, then put no more than half of remaining free cash flow into the mortgage.

      I realize you’re risk averse but optimization is your friend.

  13. I too would go along with paying off the mortgage.

    When you say “less risky bond investments”, do you mean UK Gilts, if so interest rates are pretty much at all time lows at the moment, and you can do better with the best savings account rates. Probably very little point in gilts or savings when you can get a better tax free return by paying off your mortgage.

    If you want to buy a holiday rental in 5 years time, then you should be looking at saving for that after paying off the mortgate. Find the highest rate savings accounts you can get.

    When you do get around to investing, I’d recommend the Monevator website for UK investing advice, the book Smarter Investing by Tim Hale and Vanguard Lifestrategy Funds. Start reading up now.

    1. Thanks for the website and book recommendations! I was really hoping some expert reader would chime in with some UK specific investing advice!

  14. Tara – my advice would be to do a little of both. If you are already putting at least 10% in retirement investments, then put some to the mortgage. But if you can get your retirement even higher and put some extra towards mortgage, even better. Don’t sacrifice one for the other. Good luck with your goals!

    1. Thanks for the encouragement Debs! I think a middle ground can be both psychologically comforting and also profitable.

  15. Seeing that mortgages are so different in the UK, the biggest question I have is about how the interest rates change after the fixed-rate portion is over? If it’s like an ARM here in the States, then it seems a bit dicey to me to hold the mortgage since the chances of interest rates jumping seems quite high. (Don’t think it’s likely to go much lower than 3%!) Here’s other way of thinking about it: If my cash-flow dried up, would I rather have a huge pile of cash invested in the market or a paid-for home?

    1. From what I can tell, most “fixed” mortgages in the UK do become similar to an American ARM after those first couple of years. I feel similar about interest rate risk… don’t like it one bit!

    2. Once the fixed rate term is over you probably end up on the standard variable rate. Which is likely to be more, but could be less.

      For example at http://www.moneysupermarket.com/mortgages/

      “Barclays 5 year fixed rate mortgage with a market leading rate based on a 70% LTV Woolwich from Barclays Mortgage. Market leading 5 year fixed rate at 2.99% then reverting back to standard variable rate currently at 3.99%”

      Although you probably look at remortgaging and trying to get a better deal once the fixed rate period is up. Of course fees are involved which could be anything from a few hundred pounds to a couple of thousand pounds.

  16. I don’t have a lot of background knowledge on mortgages in the UK. But what I do know, such as the fact that the rates typically aren’t fixed, I would say that it totally depends on the interest rate. Yes, the individual may be risk averse, but I think you laid out a pretty conservative investing strategy. Honestly rates are likely to stay pretty low for a long time now. The way our financial and monetary system is set up – in the US, UK, and globally – is actually pretty f**** up when you actually research it. I don’t see any of the heads of the central banks having the balls to raise rates (which they definitely should…but that’s another story). I think the best approach would be to only pay the minimum and invest the rest unless the rates really jump. In that case you could always take some of your investments off the table.

    1. Thanks for adding advice, DC! I feel like predicting interest rates is something that’s way over my head 🙂

  17. I have a 2.29% UK mortgage so I am not overpaying, although there are no penalties so I could pay £5 a month, still doesn’t make a lot of sense. I would advise her to look for the lowest rate, refinance and try to make more on the markets. I even have a 3% savings account now, so it would be foolish to pay the mortgage.
    Also, offset mortgages are good if you are risk averse. You just leave the money on a savings account and can access it but don’t pay mortgage interest on that amount.

    1. Huh, I didn’t run across offset mortgages in my (limited) research. That sounds like a plan that would have some merit with Tara’s risk profile. Congrats on having a 2.29% mortgage, that’s fantastic!

    1. According to our friend Tawcan above, it seems like Canadian mortgages are similar. So you should write it up from the Canadian perspective!

  18. I have a number of English friends and thing I thought about was locking in a home in a country where housing prices are shooting through the roof! Once her mortgage is paid off she could: rent it out at a much higher amount than what her mortgage payment was due to housing demand and limited quantities of good housing, then invest the earnings (what my bff does). While where she lives makes a big difference I would say if she’s in London she will have an amazing return on investment (even in a down market) Fun question!

    1. Yeah, we’re no strangers to the “buy in a rapidly appreciating area” strategy. It can work out really well, though I’d argue that high rate of appreciation actually makes holding a small mortgage on a place easier to swallow. Thanks for stopping by!

  19. Clueless about mortgage advice but I can say that Frugal Hound is saying less talky talky more scratchy scratchy!

    1. Uh, yes. Frugal Hound is not so interested in the blogging or the photo taking. Though she is super interested in the treats and scratches she gets after enduring a photo shoot. We try and make it worth her little doggy while 🙂

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