How should I pay off my mortgage?

Why are mortgages a hot topic today?

Complaining about interest rates has become a national sport. Actually, it’s become an international sport. That’s because central banks like the Bank of England have gone from absurdly low interest rates for a dangerously long time to one of the most quickly paced increases in living memory. That includes the biggest rate hike in 27 years in the UK.

It’s a nightmare for mortgage borrowers who are used to more than a decade of extremely low rates. The question is how bad it will get, and what mortgage borrowers can do about it.

What is overpaying my mortgage?

Interest is calculated based on how much you owe the bank. Each monthly mortgage payment includes both interest and a mortgage repayment which reduces how much you owe the bank. By overpaying your mortgage, you reduce how much you owe. And thereby how much interest you pay overall.

Early on in the life of a mortgage, most of your monthly repayment is interest. That’s what makes early repayments so effective in the initial years of a mortgage, if you can afford them.

But not all mortgages allow you to make early repayments. And some charge fees. There may be a better option.

What is an offset mortgage?

Instead of chipping away at your mortgage by paying extra each month, you might be able to use an offset mortgage. This allows you to reduce how much interest you pay, without losing access to your savings should you need them.

How does it work? When you have savings in a bank account that is linked to an offset mortgage, the bank applies that savings balance to the loan amount and calculates the interest bill as if you had used your savings to repay part of the loan.

An offset mortgage of £250,000 with savings of £50,000 means the bank will only apply interest to £200,000. That’s the simplest explanation – individual terms and conditions will vary.

The key benefit is that you still have access to the £50,000 if you need it. But if you do, your monthly mortgage payment will spike.

What happens when you pay off your mortgage?

You now own your house outright and no longer have to make payments to the lender. This should free up a great deal of cashflow and allow you to invest your savings in preparation for retirement.

However, it also dramatically reduces the capital gains you get from owning a house if house prices rise. For example, if you buy a £250,000 house with a 20% deposit of £50,000 and house prices rise 10%, your capital gains are £25,000. This means a return on your investment of 50% because you invested £50,000 and gained £25,000. If you outright own the same home and prices go up the same amount, the return is only 10% because you paid £250,000 and the house price rose £25,000.

This makes mortgages very profitable when house prices are rising. But the same maths works on the way down. The point is that borrowing money magnifies the impact of changes in house prices… for the better or for the worse.

House prices tend to rise when interest rates are low or falling. And house prices fall when interest rates are rising. This means we can look forward to falling house prices while central banks like the Bank of England continue to raise rates.

What is an interest-only mortgage?

Interest-only mortgages are not repaid over time. You only pay the interest you owe on the amount you borrowed. At the end of the mortgage, you’ll still owe the same amount of money. That is what makes interest-only mortgages risky. You will eventually have to refinance them.

Interest-only mortgages can be suitable for investors who are speculating that a house’s price will rise for the reason just mentioned above – it magnifies the capital gains. It also allows them to collect more cashflow because the monthly payments tend to be lower.

If you use an interest-only mortgage, be sure you have a plan for what you want to do before the mortgage ends.

What is a buy-to-let mortgage?

A buy-to-let mortgage is for investors looking to let their property to a tenant rather than living in it themselves. These come with different rules and constraints to owner occupier mortgages. For example, deposits tend to be higher to protect the bank from losing money. The fees are also higher as there is higher risk.

You will not be able to move into the property that has a buy-to-let mortgage on it. Although some banks provide more flexible mortgage options, a lot of buy-to-let mortgages are interest only.

Developers will often provide mortgage financing options to investors. Beware and be sure to shop around for better deals.

Fixed versus variable rate mortgages

To give borrowers certainty when they first get a mortgage, banks offer fixed terms. During this time, usually between two and five years, your mortgage payment will remain the same. After that, it depends on what the reference rate has done. For UK banks, this reference rate tends to be the Bank of England’s base rate – which is often known as Bank Rate.

If the Bank of England raises Base Rate, then your mortgage will cost more per month after the fixed period has expired. Or the rate could be lowered, reducing your mortgage bill.

People who locked in their mortgage with a new fixed five-year term before the Bank of England started hiking rates would now be protected from the added costs. For a while…

But what about now?

Should I lock in a fixed mortgage rate to avoid the coming interest rate increases?

Banks are always one step ahead of us. The question is whether their predictions about the direction of interest rates are correct.

In early 2021, banks did not expect inflation to spike, so they didn’t expect interest rates to skyrocket. They offered very cheap five-year fixed rates. That is what made locking in a mortgage rate so successful.

Today, banks are anticipating large interest rate increases. And so their fixed interest rates are very high. The bargains are gone.

In fact, the bargain might be to accept a variable rate in anticipation the banks are wrong about how high interest rates will actually go…

So, the real question is how high interest rates will go, when they will peak and whether they’ll fall back down after that.

Will mortgage rates go up in 2023?

The Bank of England and the financial markets are pricing in a lot of interest rate hikes. Although the predictions are constantly changing, as of August, the market anticipates Bank of England rates of 5.5% by July 2023. This is dramatically higher than what had been anticipated in June. Estimates also vary wildly between forecasters.

So, the answer is that nobody knows how high rates will go, nor when they’ll peak. It mostly depends on what happens to inflation in the meantime. And few have a good track record of predicting that.

It’s also worth noting that predictions would change dramatically if some sort of financial crisis began. This would likely bring down inflation and thereby negate the need for as many interest rate hikes.

What are my other options?

Because mortgages are a cheap form of borrowing relative to other forms of debt, such as a car loan or credit card debt, it can be a good idea to repay your mortgage slowly while using the money this makes available for other purposes.

Investments like stocks are supposed to rise much faster than the interest rate on mortgages. This suggests it’s more efficient to invest in the stock market than repay your mortgage. The gains on stocks will be greater than the savings on repaying your mortgage early.

However, the assumption does not always hold true. Stocks can go down for long periods of time. And the particular investment decisions you make might not be as profitable as presumed.

It makes little sense to invest in assets that return less than your mortgage interest rate, because the savings of putting that money to your mortgage would outweigh the gains from the investment. Government bonds are an example of this.

In the end, the certainty of paying off the mortgage makes it a priority, in my opinion.

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Nick Hubble
Editor, Fortune & Freedom