With higher interest rates, many investors are reassessing whether they should invest any
additional savings or use them to pay down their mortgages (to reduce their interest payments).
Both options have their pros and cons. Things to consider include your personal circumstances and goals, attitude to risk and potential cash needs, plus the amount of debt outstanding on your mortgage, the mortgage rate and any associated costs.
Our analysis shows that, even in the current high interest-rate environment, borrowers might still want to channel additional savings towards investments – in particular, if they are able to benefit from tax breaks through their pensions.
Of course, the lower the mortgage rate overall, the stronger the case for investing.
Mortgage and interest rates
After a relatively long period of cheap borrowing, in which interest rates fell to some of their lowest-ever levels, we have seen the highest mortgage rates in over a decade. It’s been a relatively sudden move too, as shown in the chart below.
Many people have a mortgage and it usually accounts for a significant chunk of their household balance sheet. So it’s important to understand the impact of higher interest rates, to better adjust your financial decision-making.
Mortgage rates in the UK so far this century
Source: Bank of England data from 31 Jan 2000 to 30 Jun 2023.
For example, consider a 25-year mortgage loan of £425,000 with a 2% fixed rate that is used to buy a property valued at £500,000. Here, a borrower would pay about £115,000 in interest in total.
But that figure jumps to approximately £320,000 with a 5% interest rate – an additional £200,000-plus in interest.
So it would only be natural, if you were lucky enough to have any additional funds (say, for example, from an inheritance, bonus or asset sale) to consider channelling them towards paying down your mortgage rather than investing.
However, there are many things to consider when deciding whether to make extra payments towards a mortgage or invest:
- Overpayment fees: Typically, there is a fee if overpayments are more than 10% of the remaining balance, although this will vary from lender to lender.
- Liquidity: money put into a mortgage might not be as easily accessible as that in an investment account.
- Tax advantages: by putting money towards mortgage payments, you may not be able to take full advantage of tax benefits on, for example, pensions.
- Differences in returns: depending on the mortgage’s interest rate, borrowers might be able to achieve an investment return that is high enough to compensate for the additional interest paid.
- Investment risk: Remember, though, that the value of your investment may fall or rise and you may get back less than you invested.
Investing or contributing more towards mortgage payments
An alternative to overpaying your mortgage is to invest the additional savings. In the chart below we compare the potential return from investing £15,000 over ten years in different scenarios, with the interest saved by paying £15,000 off a mortgage with 10 years left on the term.
To calculate the returns from investing, we use our latest market-return forecasts, based on the Vanguard Capital Markets Model (VCMM)1. This currently projects a return of 5.4% a year over 10 years for a portfolio split between 40% global shares and 60% global bonds; 5.8% a year for 60% shares/40% bonds and 6.0% a year for 80% shares/20% bonds. Remember, though, that projected returns are not a guarantee of future results.
Most people with a mortgage in the UK are aged between 35 and 55. From our client base, we find that these age groups tend to be invested mostly in global portfolios with the share/bond splits outlined above.
Our calculations also assume that the same person has an outstanding mortgage balance of £250,000 with 10 years left on the term and that their mortgage rate is fixed for five years at 5.78%2.
We consider the following scenarios:
- Invest the money: The £15,000 is invested in a global 40/60, 60/40 or 80/20 shares/bonds portfolio within an individual savings account (ISA) for a period of 10 years. This means the investor doesn’t pay tax on income or profits from the investment.
- Alternatively, the money is invested through a pension and therefore gets additional tax relief, boosting the corresponding investment to £25,000, assuming a higher tax rate of 40%3.
- Repay the mortgage: The investor could alternatively channel the £15,000 savings towards their mortgage repayments. Given that the mortgage balance amounts to £250,000 and that the payment of £15,000 is made at the beginning of the first year, we assume the borrower does not incur any early payment fees.
The chart shows the amount of interest saved over 10 years, compared with a scenario where the additional £15,000 is not paid off, assuming a 5-year fixed rate at 5.78%. After the end of the fixed period, the borrower pays a rate that is in line with market expectations for interest rates over the next five years.
Putting extra savings toward mortgage repayments is not always the best option
Investing £15,000 in a global portfolio vs paying £15,000 off a mortgage.
Source: Vanguard calculations using the Vanguard Capital Markets Model median forecasts to estimate returns from investing in a global 40/60, 60/40 and 80/20 shares/bonds portfolio as at 31 March 2023. Equity comprises UK equity (MSCI UK Total Return Index) and global ex UK equity (MSCI AC World ex UK Total Return Index). Fixed income comprises UK bonds (Bloomberg Sterling Aggregate Index) and global ex UK bonds (Bloomberg Global Aggregate ex Sterling Index Hedged). UK equity home bias: 25%. UK fixed income home bias: 35%
Monthly mortgage repayments are fixed with an additional payment of £15,000 at the beginning of the first year. The sterling overnight index swap (OIS) swap curve as at end of July 2023 has been used for the estimation of the rates subsequent the fixed period up to expiry, assuming a 1.0% credit spread.
IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model (VCMM) regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from the VCMM (in GBP) are derived from 10,000 simulations for each modelled asset class. Results from the model may vary with each use and over time.
As the chart shows, our analysis found that, by investing in the 40/60 portfolio through an ISA, the investor would potentially earn a return of £10,198 over ten years. By investing the £15,000 pre-tax through their pension account, which effectively means £25,000 due to the added tax relief, they could earn a return of £16,609.
The chart also shows the amount of interest saved over ten years if they paid £15,000 off the mortgage, assuming a 5-year fixed rate at 5.78% and average rates thereafter. The borrower would potentially be better off by £9,606 after ten years4.
In short, we find that in all the cases examined, investors would potentially be better off by investing in a global portfolio of shares and bonds and taking full advantage of the pension tax benefits.
Even if you cannot invest through a pension, you might still consider investing rather than repaying the mortgage.
However, this will always depend on your specific situation, outstanding balance, credit score and loan term, among other things. A different type of portfolio with a lower growth potential might also deliver a different result.
If in doubt, a financial adviser can take into account all your specific characteristics and help define the best course of action.
1 These projections are hypothetical – there is no guarantee of them happening – and are based on the running of the VCMM as at 31 March 2023.
2 This initial fixed-term rate assumes a spread of 1.00% over the relevant sterling overnight index swap (OIS) rate. This spread is representative of the average difference between the rates for the sterling OIS curve and the rates quoted by Nationwide Building Society with a maturity of 5 years.
3 This assumes that half of the tax relief is invested at the beginning of the first year, compounding for a total of ten years, and the other half of the tax relief is claimed back through the annual tax return and is invested at the beginning of the second year, compounding for a total of nine years only.
4 The savings would be £9,560 and £9,567 for a 3-year fix of 6.26% and a 2-year fix of 6.58% respectively.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
The eligibility to invest in either an ISA or personal pension depends on individual circumstances and tax and pension rules may change in future. You cannot usually access your pension savings or make any withdrawals until the age of 55.
Simulated past performance is not a reliable indicator of future results.
Performance may be calculated in a currency that differs from the base currency of the fund. As a result, returns may decrease or increase due to currency fluctuations.
IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model® regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time. The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include US and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, US money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.
Vanguard Asset Management, Limited only gives information on products and services and does not give investment advice based on individual circumstances. If you have any questions related to your investment decision or the suitability or appropriateness for you of the product[s] described in this document, please contact your financial adviser.
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