Sanity check on mortgage versus investing

Love-Actuary · 11 October 2016 at 6:36PM

Hi all,

I want to write down my thoughts on our debt / investment strategy and just basically see if I have missed anything obvious!

Here is our basic scenario:

- mortgaged, brand new, 25 years, 1.94% for 2 years fixed with HSBC at 90% LTV
- me, teacher, teacher pension scheme, happy with the projections for retirement and no other pension provision
- husband, higher rate tax payer, legacy final salary pension of just under £4,000 a year (current value), and a 15% DC pension through his current employer
- we have maxed out the Santander 123 account (our emergency fund)

We have about £1,500 per month currently "extra" earmarked for securing our financial position. But we disagree on what to do with it at the minute.

Husband thinks the priority is to pay down the mortgage to get us below the 80% LTV for when we remortgage in 2 years time. He thinks we should overpay every month, because the difference between the mortgage rate and the regular savers is negligble (we only have them with TSB and First Direct) but he said he'd make annual payments if I really wanted to. We can overpay 10% per year.

I like the idea more of investing that cash over a 15-20 year time frame, and basically getting to a point when remortgage means we can cash in the investments and pay off the mortgage. Husband thinks this is risky because if there are increases in interest rates or squeezes on LTV, we may struggle to get a good deal. He does think we could do this once we were at say, 60% LTV because he thinks there is not much difference in products offered below then.

He also says if we want to invest then we should do it in a SIPP instead - take advantage of his 40% tax rate, and then pay off the mortgage with a full cash withdrawal when he gets to 55.

Priority will always be given to maintaining our safe cash fund, but with the slashing of the rates by Santander we may want to look at that too.

So does anybody have any thoughts on any of the logic applied? For what it's worth, "investing" would mean an ISA with some low cost funds in there; I guess SIPP would be the same but I know his DC scheme that he self invests he is high on the risk side.

Thanks so much for what is a great community!

bowlhead99 · 11 October 2016 at 7:03PM

I would tend to agree with husband that investing while holding back from overpaying is not necessarily the smartest way to do it, in your situation where you are at a high LTV. When you drop through an LTV threshold you can typically save interest not just on the cash you just paid off, but on the hundreds of thousands of pounds you haven't paid off yet. Saving a bit of a percent on hundreds of thousands tax free is perhaps more lucrative than earning several percent on a few thousand invested.

At the moment rates are low, especially for fixes that are only a couple of years long, so it's not like an 80% LTV is going to save a whole percent on your rate compared to a 90%. But for longer fixes it makes more difference and if your money is in ISA investments that have crashed in 2 years time, you won't get the opportunity to find out.

So I would put most of the money in regular savers (nationwide and lloyds would take the £1500pm between you at 3%+ pre tax, maybe put more in your name than his if it makes a difference on the tax). After 2 years, pay down the mortgage if it gets you a good deal on the rate.

If it doesn't look great, and you are happy and confident in the idea of having a big mortgage debt with a big pile of investments to cover it in 20 years time as you suggest - put the accumulated money (or maybe at least, the money accumulating over later years) into his pension so that the big pile of investments has 40% tax relief to help you rather than just sticking it in an ISA with no income tax relief. The relief costs you flexibility of access but is valuable unless he will be a 50% taxpayer when he eventually draws it - easy to avoid.

There are all sorts of half way houses between the options. You could do £500pm in three different things.

But if paying down a chunk at your renewal point is something you're considering (and it would be cavalier to ignore the option when it's only two years away) I would avoid doing much pension now, because he will still be able to put all the money into his pension for 40% relief in two years time, and you will still be able to put money in an investment ISA in two years time (if you really really must), but he won't be able to take money out of a pension to fund the mortgage in two years time. Avoid routes that close doors.

Love-Actuary · 12 October 2016 at 9:14AM

Thanks for that - it's good to get another opinion on it.

Saving a bit of a percent on hundreds of thousands tax free is perhaps more lucrative than earning several percent on a few thousand invested.

This bit in particular is really interesting and hadn't thought of it that way before!

Thrugelmir · 12 October 2016 at 10:01AM

Personally I'd split the money you wish to "invest" three ways. Overpay the mortgage, invest in a low risk low cost ISA (money is at least accessible) and start a SIPP. That way you have the best of all worlds. As and when financial and economic conditions change you can flex the split accordingly.

I would add the caveat that if you intend moving house in the foreseeable future I would err more towards mortgage overpayments and cash savings. As the markets may have fallen significantly at the time you wish to cash in the investments. Better to know exactly where you are, then plans can be made with certainty.

atush · 12 October 2016 at 11:25AM

I agree witht eh above. You shouldnt do just ONE thing with savings, you should spread it out across different areas.

And Pensions and ISAs should NOT be neglected to just overpay a mtg (or just to save in cash).

dunstonh · 12 October 2016 at 11:37AM

Do you pay the gas bill or the electric bill? You dont pay one. you pay both. Your financial needs will be similar. You wont have one one need. you will have several.

You need money now, in the short term in the medium term and in the long term. For most people with excess earned income, the ideal scenario is to overpay into the mortgage AND pay more into their retirement planning AND make contributions to an S&S ISA. Not to be top heavy in all of those.

He also says if we want to invest then we should do it in a SIPP instead - take advantage of his 40% tax rate, and then pay off the mortgage with a full cash withdrawal when he gets to 55.

Which would likely be a very bad idea. Loads of tax to pay and a reduction in the annual allowance. That ignores the fact that returns on the pension are likely to be higher than the interest rate being paid on the mortgage.

Certainly paying into a pension makes sense. 40% tax relief is valuable whilst you can still get it. If you have children and he earns over 50k then it could also bring back child allowance. (pension contributions lower salary and bringing it below £50k allows child benefit to be paid again without deduction). That may not apply but we dont know enough about your situation to say what is best. We can only give snippets of what may be an idea.

jamesd · 12 October 2016 at 12:03PM

Pensions are perhaps the most efficient way to pay off a mortgage and are core to my own approach. But the mortgage has a lot of leverage advantage on all of the mortgage balance, not just the amount being paid off. Here are the current HSBC two year fixed mortgage rates for various LTVs and for an initial 200k mortgage amount:

90% 1.99% nil saving, current rate
85% 1.49% 0.5% saved on £170k, 1.49% saved on £10k, total £999 = 9.9%
80% 1.49%
75% 1.24% 0.2% saved on £150k, 1.24% saved on £20k, total £548 = 2.74%
70% 1.24%
65% 0.99%
60% 1.09%

So first observation is that he is wrong if using HSBC to choose 80% as the threshold because with them there is no difference between 80% and 85% LTV. The relevant thresholds are 85% then 75% then 65%.

Following the interest rate column is the potential saving from cutting a £200,000 mortgage to get to that level from the previous one that makes a difference.

Easy one first. You get an effective 9.9% interest rate on the £10k used to take the LTV down from 90% to 85%. That's a good deal in part because it is tax exempt.

Next, to go down to 85% there is just a 1.49% gain on this £10k.

Next gain comes on the extra 20k to get down from 85% to 75%. But this delivers just 2.74% tax exempt effective interest rate on the £20k more it takes to do it. Here, the current compressed range of interest rates is a big deal. Usually the margin would be greater and so would the reward be for this drop. 2.74% tax exempt might look interesting to someone with a complete unwillingness to invest.

jamesd · 12 October 2016 at 12:24PM

To expand a little on what dustonh wrote, taking the 25% tax free lump sum from a pension can be a good deal. It really is tax free with no adverse consequences when it has been done as part of a deliberate plan to pay more into a pension to help to clear a mortgage.

Take even a penny from the taxable 75% and the annual allowance for pension contributions is reduced from £40k to £10k a year for life and carry-forward from the past three years is no longer allowed. Also, the amount taken from the 75% is added to taxable income for the tax years in which it is taken.

So from a pot of say £200,000 it's completely fine to take out £50,000. But take out the remaining £150,000 all at once and that would be £150k more of taxable income for the year. That would eliminate the income tax personal allowance and have a large chunk taxed at 45% with the rest all taxed at 40% if the job is still causing the 40% tax bracket. This portion is not efficient, it's better to wait until lower tax rates apply, typically after actual retirement.

Given his apparent income it's entirely possible that a target of £400,000 in a pension and £100k as the tax free lump sum is sensible, say if there is also some early retirement desire. But 100k might not be enough to clear the mortgage.

To check the implications of a £300k remaining pension pot I used cfiresim. The initial income was £23295 with these entries changed:

Retirement end year 2055
Portfolio value 300000
Fees/Drag 0.68% to allow for difference between US and UK investment returns
Spending plan Guyton-Klinger
Pension 8000 starting in 2029 (so fake age 68 state pension age)

This analysis isn't sufficient but it's a useful starting point for planning. If an income level of 23295 a year before tax is not sufficient the retirement plan would need adjusting. Either more money or later starting date for retirement.

One thing should be clear, though, this isn't just about the mortgage, it's also about other long term financial plans. Work out what income level is needed with 75% of the pension pot and that tells you what the tax free 25% would be and how much pension money would be available for mortgage clearing in a tax efficient way.

Paying 20% income tax would also be fine and there is margin between 23295 income and the end of the basic rate income tax band for roughly 20k more a year to be taken out to use for the mortgage. So it's not quite as simple as only the 25%, it just takes a bit longer to use the rest of the pension pot after actual retirement.

jamesd · 12 October 2016 at 12:30PM

So what else might be done?

I can get 12% taxable from P2P easily on he sort of amounts you're considering, perhaps 10% after bad debt. For him at 40% income tax this would be comparable to perhaps 6% on mortgage cost reduction. Or perhaps 10% if it's for you and you're not a tax payer. So some learning about P2P seems useful.

While mortgage interest rates today are low, that may well not apply long term so it is useful to have a fair chunk of money outside a pension to allow getting down to say 75%, the traditional threshold for the most cost-effective mortgage rates. At a stretch, 60% where no further gains are typically expected.

Now isn't a particularly great time for share-based or corporate bond investing because of the current valuations. That's OK, for a long term regular saving plan, though I'd start with P2P at the moment and shift later after a drop in values. About 5% plus inflation is expected from the UK stock market before fees of perhaps 0.5%. Call it say 6.5% vs mortgage interest rates. That usually makes investing outside a pension or inside a better deal than mortgage overpaying.

jamesd · 12 October 2016 at 12:36PM

Now, an integrated plan.

1. Forget 80% if using HSBC, it makes no difference compared to 85%. 85% does look like a good plan so go for that with a two year target. Remember that property values can go down as well as up.

2. Determine what the retirement plan looks like for the two of you combined and put both of your anticipated income streams into it along with your household income desire. See what that does to your desired pension pot target size at a particular age. Then work back from there to work out what the 25% of the pension pot is worth and how much can be used to pay off the mortgage with the greatest efficiency. Use the whole 25% if needed and perhaps five years of 20% taxed money.

3. Consider investing outside a pension more money to allow you to get to 75% LTV in case mortgage rates increase substantially and the interest rate benefit of a drop to 75% becomes more substantial.

4. Overpaying does not currently seem efficient compared to investing vs the HSBC mortgage options one you have reached 85% LTV.

5. Overpaying is not an efficient way to get the LTV down to 85%. Investing then selling the investments looks more efficient if using P2P where exit on time is readily doable then a lump sum payment can be used to get the reduction needed.

Love-Actuary · 12 October 2016 at 1:24PM

Thrugelmir wrote: »

I would add the caveat that if you intend moving house in the foreseeable future I would err more towards mortgage overpayments and cash savings. As the markets may have fallen significantly at the time you wish to cash in the investments. Better to know exactly where you are, then plans can be made with certainty.

You can of course never say never but we are hoping this is our only home, prior to downsizing in the future (i.e. at retirement)

Sanity check on mortgage versus investing

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