Your questions answered in Fundraising Fortnight

I have been offered a fee (of the scale of two steak dinners for two/box of Cuban cigars level) to answer the following question:

Basically I\’m wondering how to weigh up the pros and cons of using spare income for either
a) investing for my retirement (probably as index trackers in an ISA)
or
b) paying off mortgage.

Both are a form of investment- deferring present consumption for future benefit- but which, I am wondering, likely to put me in the best position in a decade or so from now?

With the obvious proviso that I\’m neither a tax nor investment advisor here goes:

My personal preference would be to pay down the mortgage.

Now both are, of course, deferrals of current consumption and as such should make one better off in the future.

And certainly, index trackers in an ISA are the both tax logical and individual investor logical ways to save for the future.

Tax because one can put the money in tax free and, as we also know, any dividends reinvested or capital gains over the life of the ISA are tax free. Trackers (and make sure it\’s a low load one) because the efficient markets theory does indeed hold in its weak and semi-strong forms. Markets, when considering what prices should be in a market, are efficient at processing the information about what prices should be in a market.

It is thus (leaving aside the strong form of EMH, where even this doesn\’t hold), unless you have special information unknown to the rest of the market, impossible on anything other than a statistically random basis to consistently beat the market.

So why would I prefer to pay down a mortgage? At least in a tracker there is the possibility of a rise in the capital value…..

Well, it\’s true that there are no longer tax advantages to mortgages. However, given the way that my income bounces around (the evidence of the last decade is that it can go from £20k one year to £130k the next and then back again) it is uncertainty of income which is my major concern. And a mortgage is a fixed cost (well, as long as interest rates stay stable). So, in those good times, rather than socking money away that I cannot touch for 10 years (?) I prefer to reduce what I know I\’m going to have to pay in a year or two when, depending upon the vagaries of the freelance and or scandium markets, I may or may not have the cash flow to keep the mortgage payments up to date.

Which brings us to two further points.

The first is that we are all, as I think we know, in somewhat uncertain financial times. As someone who has lived their entire working life with such uncertainty, here\’s my recommendation for how to deal with it.

Pay your mortgage forward (we are, of course, all assuming here that there ever is a surplus over current expenses: but then that\’s obvious from the very question at the top) by three months. It\’ll cut the amount of interest you pay over the life of the mortgage a bit: but much more importantly, if there is an interruption to your income this will give you three months grace with the Building Society before they start to get nasty.

\”You know I paid you two mortgage payments one month last year? Well, I\’d like to skip a month now\” works much better than \”I\’ll pay two months in the future if I can skip one now\”.

You should also (again, subject to resources) have a nice high interest (I know, it is to laugh these days!) account that has three month\’s worth of non-mortgage living expenses in it.

Finally, you should of course pay down all of your higher interest consumer and credit card debt. Any store cards, HP on a car lease (if you can do it) and so on, pay them all off.

And finally finally, I think it\’s fairly obvious that interest rates are going to go up at some point. Whether the withdrawal of QE will crater share prices or not I don\’t know (see EMH above) but clearly and obviously mortgage interest payments are going to rise in a year or three. So while there is spare cash around from the current low rates, reduce the amount you\’re going to have to increase payments then they rise.

And as a stock picker? Well, there\’s that pesky EMH in there. But FTSE 100 these days is really a barometer of the global economy, not the national one. FTSE 250 or 350 (??) is more about the UK. I don\’t think it\’s all that controversial a point to think that the global economy is going to do better than the UK one over the next 10-20 years. It\’s what the whole idea of climate change is predicated on for example. If I were to be buying trackers I\’d go for global, not local ones.

So, now over to the readers here who obviously know more about this than I do. What is the real advice in this position?

And finally, finally finally, do send me an email if you have further questions to be answered in this format. Bile and venom can be added to taste. I am even, for a price, willing to let out Timofei, my mirror image alter ego….

26 comments on “Your questions answered in Fundraising Fortnight

  1. I think inflation is something to take into account: stocks are (sort of) protected against inflation, but mortgage debt (on fixed rates) will be eroded (especially so if Sterling collapses – perhaps if politicians take the ‘easy’ route of monetising the deficit).

  2. Do both!

    Use te money you would have otherwise put in an ISA to put into a spreadbetting account – they are currently tax free.

    Use that money to synthesize the same risk as the money you woudd be putting into the ISA (i.e. 7k in the FTSE). Given that spreadbetting is leveraged, leave a stop-loss order. However, they beauty is that thanks to that same leverage you can gain the same tax free exposure without tying up as much of your cash….which you can then use to pay off the mortgage.

    In general though, beating the taxman is the most efficient way of earning a return if your considerations are *purely* financial, as opposed to other considerations as Tim mentions above.

  3. This is a bit like repayment vs endowment mortgages – can you still get them?

    You could of course look historically at any single point in time. I don’t have time to do it (but it wouldn’t be hard) but I’d imagine it was better in equities until about 2000, and perhaps has been worse since.

    I think some of your points are misleading. Overpaying your mortgage will cut the interest paid, but this is no different than the interest you would get by putting it in a bank at the same rate of interest, or get from divs/capital gains in equities. Also its not obvious that higher GDP growth translates to higher equity returns, and there’s higher costs and political/currency risk to consider.

    I think equities will outperform interest rates but I’d still pay off the mortgage. They’re usually enormously leveraged loans, after all.

  4. Get a flexible mortgage, where you can make overpayments, which can be withdrawn later. This functions both as a savings account AND as a guarantee of a mortgage holiday should you need one.

    Interest saved is tax free. Interest earned is taxable.

    Therefore it is better to overpay a flexible mortgage than keep living expenses in a savings account.

  5. ISA allowances get reset every 6 April. If you haven’t used up your full allowance, you should think very carefully. Gains and income within the wrapper are (for now, at least) tax free. If there are any investments outside the wrapper it might be worth “Bed & ISA”-ing them before the end of the tax year, if there is spare CG allowance.

  6. ideal would be an offset mortgage, but possibly too late for your questioner to get one

  7. My take would be that if you pay off your mortgage you then own a house outright, whereas if you invest, you’re taking a risk on the bank not going bust, the State not debauching the currency, etc etc, and in the case of an ISA you’re assuming the tax rules won’t change.

    Seems like a no-brainer to me.

  8. I’m all for paying down debt or not getting into debt in the first place. Call me ‘old school’ (well quite old), but I was brought up to believe that if you can’t afford it save until you can. I’ve always done that except for the house(s) where there is little choice.

    So I’ve only ever had a mortgage debt and when the recession was obvious (autumn 2007 – Northern Wreck), I had five years left to pay. I contemplated paying it off but most of what I was paying back was my own money – interest is paid upfront, of course. So I left it and left the money in the bank. I wish now I had paid it off because the couple of thou’ of remaining interest far exceeds what I’ve earned in interest on the money in the bank.

    As for ISAs, I started a FTSE ISA in 2008 at the bottom of the market and cashed it in a few weeks ago and made a tidy sum – FTSE up 4000 to 6000.

    I’d rather have an ISA than a pension because the pension companies pocket your tax rebate in their deal and charge management too.

    So, I’d pay off the mortgage asap given the low interest rates. I’d take out an ISA but a FTSE ISA is looking a bit of a problem at the moment so I’d go for a money ISA for the time being.

  9. wonders if Matthew can suggest an account where you earn interest at the same rate as you currently pay on a mortgage loan?

  10. Having had an endowment mortgage and a repayment one. I’d say pay the mortgage off. At least you’ll have somewhere to live when the stock Market collapses.

  11. Banks make profits on good mortgages to cover the losses on ones that default and their admin costs, so unless you are planning to default on your mortgage it makes sense to pay it down rather than put money into a cash ISA. The interest saving will be more than the interest received in the ISA. Likewise it makes more sense to pay off all the high-interest-rate debt first – the excess interest that you avoid paying will enable you to reduce the mortgage in future months.
    The question of an interest-tracker ETF in an ISA (or a SIPP) versus paying down the mortgage is a bit more debatable and depends on (i) most importantly, is the stock market over-valued* or under-valued so what is the expected return on the ISA/SIPP in the medium-term? (ii) what are the charges involved (a lot of ISAs charge 1% pa just for holding the ETF in the wrapper and since you can no longer reclaim the imputed tax on dividends, an ISA only benefits a higher-rate taxpayer or a basic rate taxpayer who habitually exceeds the CGT-free limit on capital gains. Saving for retirement through a SIPP (for the rich) or a stakeholder pension (for the rest of us) makes more sense that an ETF ISA since you get tax relief up front on the whole lot that usually more than compensates for the tax payable on three-quarters of the fund after retirement. [I assume that you have been asked by a UK resident since ISAs are as irrelevant as SIPPs to non-residents who do not plan to return to the UK]
    There is no simple answer that suits everyone and a lot will depend on your income/expenditure balance in that decade’s time as well as investment performance. If you are 40 and expect to have to make a lump sum payment when you are 50 then an ISA makes sense as you cannot (under current rules which may change – see Ros Altman’s argument that accessibility of funds would encourage more saving for pensions) get the money out of a SIPP or stakeholder early. If not then a SIPP would leave you better off than an ISA.
    Rule 1 – analyse your liabilities/ future needs and design your investments to match them. Rule 2 After doing that, consider future desires and design any surplus left over from Rule 1 to satisfy those in order of priority.
    The question implies, but does not state, that there is surplus cash and that implies to me that there are no high-interest unsecured debts – if there are the cash isn’t surplus and there is no ETF that is going to provide a return in excess of the interest on a credit card. So which is more valuable to you, peace of mind about the mortgage if you are unsure about future income or the higher expected return from a SIPP/ISA?
    My personal (and at this point it’s personal not professional) is pay down the mortgage until you (and wife, where appropriate) stop worrying and put the rest into a SIPP unless you expect to need some of it before you retire (in which case enough to cover pre-retirement needs into an ISA if the tax-savings exceed the fees and into a direct investment if the ISAs fees would wipe out the tax savings). Since the EMH has been repeatedly refuted by market practitioners and the arguments for index-trackers rely on the non-existence of death and taxes (also on comparing returns on trackers before expenses with those on actively-managed funds after expenses), please, please, choose an ETF that is appropriate to your tax position/tax wrapper not an index-tracker.
    *As you may gather my view is that the stock market is currently less overvalued than gilt-edged, and so the up-front tax relief makes a SIPP a plausible option, but the future is sufficiently murky that I shouldn’t like to say that equities deserve to stay at the current level when real interest rates get back top +1% or +2%.

  12. @diogenes: Woolwich offset mortgages. All depends if it’s worth the cost of moving your mortgage there though.

  13. Tim, in all seriousness I think your first paragraph should read –

    “With the obvious proviso that I’m neither a tax nor investment advisor, and accepting no liability for what might happen to anyone should they act on my suggestions, here goes -”

    Just to keep yourself straight.

  14. Soon, very soon, the UK government will steal your homes. I dunno how they will do it, but they need the money, they are politicians, and consequently amoral sociopaths and they will find a way.

    The only asset worth owning is an asset that can be hidden or moved quickly.

  15. Noise is costly. The very fact that there have been near twenty responses to a putatively simple question is illustrative. Uncertainty has a monetary value. Please, Mr. Politician, tell me what the fuck you want to do with my pension fund. OK, use it to finance a boondoggle for your mistress. I can plan for that. I don’t like it, but it’s knowable. But some blue-sky happy-clappy bullshit ten years down the line? I cannot plan for that, so fuck off and die.

    Problem is, just the sheer friction of having to comply with the nonsense that the statist cunts have inflicted upon us over the last half-century is scarcely calculable, but a finger in the wind has its cost in the trillions. I would have them all boiled.

  16. Diogenes – the point is about equity gains, not interest rates, and they have often been larger than mortgage rates. But the point I was trying to say is people are very quick to note benefits of compound interest on paying off mortgages, less so on savings (but they are the same).

    As it happens I get quite a bit more on my savings than I pay on my mortgage (1.49%) but that isn’t going to last for very long, sadly.

  17. I am the author of the original question.

    I’d like to thank Tim for hosting the discussion, and everyone who’s contributed an answer.

    I acknowledged when raising the question by private email with Tim that he’s not a financial, tax, or investment advisor. Tim isn’t responsible for the consequences of what I do, and nor is anyone else contributing on this site. I’m a big boy, and after I’ve considered all the points raised, what I do is my decision and my responsibility. I do agree with Martin (#18) that it’s wise for Tim to cover himself, though.

    I think it might help if I cover a few points by clarifying my specific situation. The original question is very generic, and I think specifics will help in the understanding of the issues.

    I appreciate that moving from generic to specific may reduce the applicability of the discussion to someone in a different position, but hopefully it’s also interesting to go though a ‘meaty’ real-world case study. I think, if we work through to the end of it, the underlying principles will actually be quite widely applicable. If anyone wants to skip the details of my individual situation, they could jump straight to ECONOMIC PRINCIPLES below.

    It is not from my benevolence that Tim expects his steak dinner, but my self-interest! However, I am very grateful for the benevolence of everyone contributing their thoughts.

    DETAILED CONTEXT

    Now… my financial situation. As various people have said, mortgage-Vs-ISA isn’t a decision that can be made without knowing the context. So here it is.

    I have no debts other than a mortgage, currently about £69k. As various people have pointed out, if I had other debts I wouldn’t be sensible to be asking this question, as clearing them would be a higher priority.

    The mortgage covers a flat where I used to live, but which I now rent out. I live with my partner, who has paid off her mortgage and has no debts.

    My current mortgage rate is variable, BoE base + 2%, and I’m wondering about remortgaging to fix or cap the rate, to safeguard against likely increases. Monthly payments are £515.

    At the moment my flat is worth about £120k, giving a loan-to-value ratio (LTV) of about 57%. Getting under 60%, so as to get better deals, was a target I had when considering capital payoffs in the past. Getting to 50% would require me to throw in about £9.5k. The difference between mortgage rates at 50% LTV vs 60% is about 0.2%.

    Tim makes a good point about fluctuating income, and sweetening the mortgage lender by making up-front payments. I’m a contract worker, with variable income- not as variable as Tim’s, but I could have a bad year. However, in the last 2.5 years, I’ve already made extra capital repayments, equivalent to about 2 years of normal monthly payments. So my current lender should already be pretty sweet!

    I already have plenty savings set aside for emergencies or bad years. As suggested by Leftyorrighty (#8) I am considering an offset mortgage, so as to let these work more efficiently for me.

    My immediate context for a payoff-vs-ISA decision is that I expect to take dividends out of my company between now and April 5th, giving me £10k-£12k to use wisely.

    I’m 48, would like to retire at 60, mortgage currently runs out when I’m 62. £6,200 now would bring that forward by 2 years.

    My retirement plans are based on a final salary pension from BA, which should provide about 25% of what I need to live on; rent from my flat (33%); state pension (13%!); a stakeholder pension to which I’m paying about £5k/year (17%). That leaves about an 8% shortfall, which is where ISAs etc come in. I would hope to invest enough, by the time I retire, to have about 120% of what I need, so as to have a margin of safety.

    ECONOMIC PRINCIPLES

    Now… economics. I can hear people out there shouting “Well, pay some mortgage off, you plonker!” They may well be right- but maybe it’s not that simple.

    I think a lot of what I’m struggling with is the difference between nominal and real returns, and how to account for that.

    BIG QUESTION 1: inflation. I have read in various places that the Government is secretly quite happy to let inflation rise, so as to let it reduce the real size of the national debt. So, I wonder… is it in my interest to make real payments to my mortgage, if inflation is going to erode my debt in a similar way? Kay Tie at #1 has crystallised the issue.

    BIG QUESTION 2: investment returns vs interest rates. I’m currently paying 2.5% (nominal) on my mortgage, and therefore that’s what I save if I pay it off. I’d expect an investment in a cheap tracker, bought now and held indefinitely, with dividends reinvested, to do a lot better than that. (Of course, both interest rates and investments returns can change in the future, which is what makes this question interesting.)

    So there are two possible reasons for putting my money into an ISA tracker rather than paying off mortgage. The problem is, how much importance to attach to those issues? Neither of them, as far as I can see, is so clear-cut as to make the decision a no-brainer.

    It seems likely that the best decision may vary from year to year- maybe I need to clear mortgage when the stock market is expensive, and buy stock trackers when it’s not? (As per John77 at #16.)

    Some may suggest I clear mortgage first, and then buy stocks afterwards. That could mean that I was starting to buy stocks at 53, aiming to retire at 60- which is a rather short timescale for that kind of investment.

    If anyone could very kindly supply me, in the next week or so, a copy of the Financial Times dated 31st December 2022, then I think I could solve all my problems. In the absence of that, can anyone shed any light on those two big questions?

    Cheers
    CJ Nerd

  18. Your biggest problem is tax. Interest saved is tax free. Interest earned is not (except in an ISA of course). But they compound at the same rate.

    Overpay your mortgage and you have a guaranteed borrowing facility if you need it, and mortgage gives you a guaranteed 2.5% with no fees or deductions, and no withdrawal penalties. You can expect to beat that on average, but not guaranteed.

    Also if you are 48 you are too late to invest in equities and expect to get a “long run guaranteed” payoff. Historically speaking there have been many 10 year periods where trackers have lost money.

    My advice: keep your money where you can see it, so no ISAs or lock-ins. Pay your mortgage off.

    Or better still, emigrate while you are still of working age and still can.

  19. Two things here.

    1) Real returns

    A combination of income returns, capital returns and tax.

    Usually we’d say that interest earned is likely to be less than interest payable – bankers have to make a living like the rest of us.

    And certainly once you add in tax, interest earned (taxable) is likely to be less than interest payable on a mortgage (not tax deductible). So pay off the mortgage.

    But in this case it’s interest on an ISA (non-taxable) vs interest payable on a mortgage on a rented property (tax deductible), so the calculation may be different.

    Of course you can increase the investment risk in return for a hopefully higher return.

  20. Following on from above:

    2) Cashflow risk

    If your income is fairly certain, then follow (1) above and just look at the returns.

    But if your income is variable, you need to think about cash reserves or equivalent.

    Sadly it’s optimistic to say that pre-paying part of a mortgage will help much if you struggle to pay in later months. Unless the mortgage deal specifically allows that, which on a mortgage for e rented property is unlikely.

    So if you have variable income, so think there’s a risk that you won’t be able to pay the mortgage at some point in the future, then it’s better to have savings to cover a few months of mortgage payments than to have paid off part of the capital. Even better if that few months of payments is in an ISA, so that the returns are tax free.

    So if your mortgage deal gives you future allowances for pre-payment (i.e. you can pay off part of the capital now, reducing your interest charges, but later miss payments up to that amount) then pre-paying the mortgage is attractive.

    This also works if you have an offset mortgage, where you have a linked mortgage and savings account.

    But for a normal mortgage, and an uncertain income, than from a risk point of view it’s better to have a few months worth of savings to avoid possible default.

  21. It’s then weighing up the returns (including tax issues) vs risk (particularly the risk of being unable to meet future mortgage payments).

    Of course if you’re looking at paying off the mortgage entirely then the situation changes (because the risk of missing future payments goes away), but that doesn’t seem to be the situation here.

Leave a Reply

Name and email are required. Your email address will not be published.

This site uses Akismet to reduce spam. Learn how your comment data is processed.