Should Our UK Reader Pay Off Her Mortgage?
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!
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.
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.
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.
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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