Coming into some money - pay off half of interest-only mortgage or invest so can eventually pay it off in full?

[FungalToeBogeyman]

We took out an interest-only mortgage pre-recession, when our circumstances were very different and we were in a position to save towards repayment.

A few years later, DP, who was a high earner, developed mental health difficulties which affected his ability to work. Now, I'm the main earner, and my job is much more modestly paid. So while we can afford the monthly interest payments, we can't put more than a few hundred away each month towards the eventual repayment. The outstanding borrowing is £260,000.

In a few months, very luckily, I'm due to come into some money, and it will be enough to pay off nearly half the mortgage – a bit over £100,000.

What I'm wondering is, do we pay off a huge chunk of the mortgage with this money or, where the interest we pay is very low (1% over base rate), would it be better to invest it and, by the end of the mortgage term (about 20 years), have enough (with average growth of 5%) to pay it off in full?

I like the idea of seeing the overall borrowing reduce by nearly half, and knowing that when interest rates rise, we'll be able to afford the payments comfortably. However, even with nearly half the mortgage paid off, we still won't have the means to repay in full simply by saving each month, especially when interest rates rise. Nonetheless, we want to keep our settled DC here if at all possible.

My financial adviser recommends investing the money, at least initially while interest rates are still low in relation to the return we could achieve by investing, but I'd just like to get a second opinion.

What do others think? What would you do?

Thanks.

I hope you're not a financial adviser, Sydlexic!

Can you pay off half (or as much as possible) and then switch to a repayment mortgage, or else over pay by keeping your payments as they are now so that you drive the capital loan down?

I would be afraid of interest rates rising.

It comes down to maths really. I note that your interest only mortgage is at a very low rate - 1% above base rate probably equates to 2.5% or so? - you should be able to invest the money and achieve a higher return than that. If you remortgaged and switched to a repayment deal the best you'd get is around 4% so that doesn't actually make financial sense.

If the interest rate went up and/or the return on the investment didn't keep pace that would be the time to pay off the capital.

So I agree with sydlexic. :)

But if she didn't remortgage at all and paid off the loan there are lots of psychological reasons and security reasons why that might be wise, even if there were remortgage which might be to a higher rate. She could then save the difference between the current loan cost and the new one after the repayment and pay that off the loan each year.

I agree with Sally. Pay off mortgage and then see if you could manage to change to a repayment mortgage.

Psychological reasons are debatable but I would argue that the security aspect would be just as strong with £100k earning 3%+ invested or on deposit as it would be paying down the bricks and mortar. The crucial piece of information here is that the current mortgage is only 1% above the base rate which is much cheaper borrowing than any product currently available. If the OP changes to repayment (4% interest typical) they are instantly worse off.

But she doesn't need to change to repayment, she is on interest only with no penalties - she can effectively treat it as a repayment.

Plus looking at returns on investment she needs to factor in tax implications.

Absolutely, she doesn't need to change to repayment. It's just that I'm conscious quite a few people are suggesting that plus accusing the financial adviser of being a shark for recommending the money is invested. What tax implications? CGT? Income tax on interest?

Yes I was a mortgage consultant for a long time, not currently.

My mortgage so 1% over base currently

My investment returns 4.5 %.

All of the comments people make about repayment mortgages are usually correct but a lot of people took out fixed rate loans that were fixed at a percentage above base that now gives them a ridiculously low rate no one could have predicted.

Do NOT lose your interest only mortgage - IO mortgages are fantastic if you are disciplined. they give you and your family far more flexibility to adjust your payments if/when necessary.

If you pay down the capital on your mortgage you are dramatically reducing the overall amount (interest plus capital) that you ultimately pay on your MASSIVE DEBT (which we like to refer to as mortgages since that doesn't seem as scary), particularly if you still have a long period left on your mortgage. Take a look at the overpayment calculators on moneysavingexpert. Pay off the mortgage and if you really want to just keep £10k out to play with in investments. But be prepared to lose it or for it not to have served you as well as it could have.

sydexlic

1 percent over base so 1.5 percent on a long term loan

4.5 percent - less tax of course

With the fact that the capital payment will dramatically reduce the interest payable over the lifetime of the mortgage loan the capital repayment on the mortgage loan is a safer and probably financially better option depending on tax bracket.

Most people aren't disciplined. If the £100k is put into savings could be frittered away on holidays and sometimes people's partners spend it. if you pay it off the loan it is over and done with and when rates return to 8 - 12% you will be glad. I think for a loss of what will probably be about 1% difference after tax it would be best to pay it all off the loan and as said above you are saving the interest at what in future could be 6% a year over 30 years, not just making a saving in this tax year. I would pay it off. Indeed that is what I have been doing so I'm only justifying my own position here but it has worked for us.

Most people don't get 4.5% investment returns before tax and if you go for more risk (I choose the shares in my pension fund and manage them and they go down as well as up of course although last year shares did very well but you can never be sure) you could end up with less than £100k never mind £100k plus 4.5%.

I would pay it all off the mortgage, keep the rest as interest only and save each month the saving and then pay that off the mortgage that remains once a year.

absolutely agree Laura

I note that you are a DP - not married.
If you own your house as joint tennatnts rather than tennants in common I would take steps to preserve this £100k as mine. If you do put it into your mortgage as a lump sum and are tennants in commmon you are in effect giving your DP half.

Up to you of course, but make it an informed choice.

Very good point. If she is not married and owns a house jointly as joint tenants she is giving him half of it if they split. If instead she keeps it as savings in her name only he cannot get his grubby mits on it if he runs off with a lover or if she puts the house as tenants in common earmarking her higher share as hers. Worth making a will too.

Little squirrel. The problem is that the lenders want to get out of these contracts so won't let you pay off some of debt. It means clearing the debt with a new mortgage for the remaining balance, this would be a much higher rate.

I did the calculations for my personal circumstances taking into account everything and this was definitely the better option.

I defy anybody to find a risk-free, post-tax return of 4.5%.

In any event, an equity investment (which, as others have noted, is far from risk free), would need to be held for at least the medium term, by which time the base rate, and the monthly cost of the OP's mortgage, will have gone up. Rather negates the exercise, doesn't it?

The OP should certainly pay down the mortgage. Who's to say that the lender won't permit capital repayments on the current mortgage, or would insist on a remortgage?

Sydlexic Only if you have a rubbish mortgage which doesn't allow overpayments. Many many do nowadays. And in any event even those that don't allow free overpayments tend to allow overpayments for a penalty charge which in some circumstances would still be worth doing.

Sorry, I think your advice is incorrect and out of date.

I though OP said she could pay some of the capital off without penalty so no need to change mortgage.

I would be concerned about getting hold of any invested money quickly if it was needed as any financial adviser should be looking longer term to maximise growth. We have had very good growth rates with a portfolio of unit trusts but they go down as well as up so cashing in would not always be a sensible thing to do if you happened to be on a down. However the £260,000 capital will have to be paid off at some point and it is a gamble which may result in the house being sold and there being enough profit to pay off the capital. If this scenario is unpalatable, then pay off some of the mortgage but draw up an agreement with DP regarding ownership percentages if this is a concern. Who has paid in and who gets what out. You could use the windfall and get married of course!

"as an example my SIPP is up 20% in the past ten months"

that's great, Charley.

But would you like to divulge how your portfolio performed over a different period? Let's say, Jul 2007 to March 2009? Or, maybe, Feb 2001 to March 2003? Or July 2011 to Aug 2011?

If I came into £100,000 I would divide it into chunks and invest in different things. You can get a cheap property in London for letting out. Rent will be almost certain and outgoings minimal if it's a small one bedroom. It will be an invesment and unlikely to go down in value.

Diversifying is a good idea in general, although not sure how far 100K would go in London on a rental property. But the OP is sitting on a huge quantity of debt with no repayment plan.

Btw, in terms of penalties, there were none at all for me when I paid a chunk off our interest-only mortgage, the bank simply recalculated the monthly payments.

What are you planning to do in 20 years when the mortgage ends? If you want to sell and move to a much smaller place, then that might affect whether you pay off some of the mortgage now.

Eg if you have outstanding mortgage of 260k and the house is sold for 400k then you may still have enough to buy a smaller place outright. In that instance I would be tempted to pay off some of the mortgage now and then save more per month or overpay more given that the repayment will be less. That way when you come to sell then the mortgage would be way less than the selling price and you could well afford to buy a smaller place with no further mortgage.

If you plan on keeping the house once mortgage term ends however, I think you need to look into investments. Whilst I think getting it to more than double in 20 years might be a tad optimistic, you can certainly get a better rate of return than you would save by paying off the mortgage, so it would be worth looking into. Even better if you can continue to save money monthly and maybe make some overpayments, so that when you get to the end of the mortgage you will have less to repay and an investment to cash in for more of it. You would then maybe need a small mortgage but you would have reduced it as much as possible.

If the OP has a 1% mortgage then she would be silly to touch it. To buy a rental property most mortgages insist on 60% loan to value and you have to have a salary of 25K. She could buy a property and have a repayment buy to let mortgage on it. The rental income would pay the repayment mortgage easily. You would have to pay income tax on the rental income as well as maintaince costs on the property. The UK population is increasing rapidly and demand for property is unlikely to fall. Even if property does not increase in value over the next twenty years you would have the mortgage paid off.

If I was the OP I would have two rental properties outside London.