Why I plan NEVER to pay off my mortgage
By ChrisGilchrist     4th September 2007

Most people believe they'll be better off by paying off their mortgage as fast as possible. They may be emotionally right but financially they're wrong. I plan never to pay mine off. Here's why.

"Debt: an ingenious substitute for the chain and whip of the slave driver," says The Devil's Dictionary. That's how most people feel about it, and while we don't have the moral aversion to being in debt that was prevalent in the 1960s, most of us still feel that debt is oppressive and look forward to being 'free of debt'.

I say this is confusing cause and effect. Yes, consumer debt on which you are paying high rates of interest is bad for you financially, so the best thing you can do is pay off your high-interest credit cards, overdrafts and personal loans as fast as you can. But long-term debt used to build wealth is totally different.

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Gearing is good
Let's start with the obvious. If you buy a house worth £200,000 with a £100,000 mortgage and house prices rise by 10%, you have not made a 10% profit. You only put up £100,000 of your own money, and on that you have made a 20% profit.

This is the reason that people have, on the whole, made more money out of property than shares - because their investments in property have usually been financed with borrowed money. I can assure you that if you had had the courage to buy shares with borrowed money, you would have made far more money over every 25-year period since 1900 than you did through home ownership.

So 'gearing' - the use of borrowing to generate higher returns- has worked for us in spades in the home ownership market. And the people who it has worked best for are those who have steadily increased their level of borrowings to finance the purchase of costlier houses.

If you owned a house worth £100,000 five years ago outright, it would now be worth maybe £200,000. But if at that time you had moved to one worth £200,000 with a £100,000 mortgage, it might now be worth £400,000 and instead of having capital of £200,000 you would have £300,000.

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The lenders are getting more aggressive with their charges
You can see from the examples above that re-mortgaging can save you money, even over short periods of time and with today's very large arrangement fees. What does this mean for the future? Possibly that arrangement fees will rise further, or that other 'admin' charges will creep in to reduce the benefit.

For now though, for most people paying a Standard Variable Rate (SVR) re-mortgaging is still worthwhile. If you are not on an SVR and/or you face an early redemption penalty if you wish to get out of your current deal then your situation is more complex. Do your sums carefully – or take advice – before jumping in.

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Being swayed by emotion
So gearing is good for accumulating wealth. Why, then, are people so keen to pay off their mortgages? I believe there are several reasons:

• So long as you owe money on it, it's not really 'yours'.

• Paying the interest comes out of your bank account now, while any increase in capital arises only when you sell, maybe years in the future.

• By paying capital off the mortgage, you save many years of interest payments and the total amount you save can appear enormous.

• People find it easier to discipline themselves to make extra mortgage repayments than to put the same amount of money into savings plans

But ask yourself this: would you invest your money for 25 years for a 5% return? I hope not, because history tells us that as long-term investors we should earn an average return of 5% a year on top of inflation - whatever the inflation rate happens to be. Yet at current interest rates, if you pay capital off your mortgage, you are earning an annual return equal to the rate you pay on your loan, which should be around 5.5-6%.

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when it's bad, it's good
I have always taken the view that on a long-term basis, I can and should earn more from saving and investing than the rate I am paying on my mortgage. Of course there have been periods when that wasn't true, but even they are good news once you adjust your viewpoint.

When interest rates rose in the early 1990s and the stock market was low, the money I was putting into shares in savings plans wasn't earning an annual return equal to the 11% I was then paying on my mortgage, but it was buying more cheap shares - so even though at the time the returns were poor, when share prices went up, the annual returns on those savings soared.

Indeed, by the end of the 1990s, annual returns from regular savings plans in unit and investment trusts reached 15% or more - way ahead of inflation or the average rate paid on a mortgage.

So the combination of an interest-only mortgage and a stock market savings plan has strong arguments in its favour. The reason this has gone out of fashion is the 'low-cost with-profits endowment policy'.

These mortgage-linked policies, widely sold by banks and building societies in the 1980s, appeared to reduce the risk of investing in the stock market but ended up increasing it and are leaving millions of homebuyers with 'endowment shortfalls'.

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out what you need to save
The buyers of endowment mortgages got the whole concept wrong, because they were advised to pay too little into their savings plans. Here is how to ensure you get it right.

Use a mortgage calculator to tell you what the monthly repayment would be if you had a capital-and-interest-mortgage. Deduct from that the amount you pay with an interest-only mortgage at the same interest rate.

The difference, paid into a regular savings plan each month, needs to earn the same net annual return as the interest rate you're paying on the mortgage for you to be able to pay off the loan at maturity. A higher rate of return will leave you with a surplus.

On a £100,000 mortgage over 25 years, a capital-and-interest loan at 6% costs £644 per month while an interest-only loan costs £500 per month. The difference of £144 is what you need to pay in to your savings plan each month. If it earns an annual return of 6%, you'll have £100,000 in the plan in 25 years' time.

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beat cash most of the time

Since 1900, shares have produced higher returns than cash in about three-quarters of all five-year periods, in 90% of all 10-year periods and in 99% of all 18-year periods, according to the 2006 edition of the authoritative Barclays Equity-Gilt Study. So the odds are stacked in favour of coming out ahead by using an interest-only mortgage and a regular savings plan.

How big a surplus you end up with will depend on how good the investment managers of the funds you hold inside your savings plan are. That is why I recommend you start such a plan with a self-select ISA with a fund supermarket like FundsNetwork, so that you can alter your fund choices and, after a few years, build up a portfolio of funds investing in different areas, and can - as the maturity date of the loan approaches - switch to safer funds and even into cash deposits.

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Fixed or variable rate deal?
The calculation I refer to above is valid only if you have a fixed rate mortgage. If you have a variable-interest mortgage, the proportions of interest and capital included in each monthly repayment change along with interest rates. What happens when interest rates fall is that your capital repayments are accelerated, so that overall you pay less interest.

When interest rates rise, more of each monthly repayment is interest, so capital repayment is deferred, and you end up paying more interest. This means you need to review your plan every time there's a change in interest rates.

Let's assume you do the comparison I set out above on a £100,000 variable-interest mortgage when the interest rate is 6%. The capital-and-interest monthly repayment is £644, the interest-only repayment is £500, and you start a monthly savings plan for £144 per month, the difference between them.

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Adjust your saving amount to match interest rates
Next day, interest rates are suddenly cut to 5%. What do you do? The calculation now runs as follows: the capital-and-interest monthly repayment drops from £644 to £585, while your interest-only repayment falls from £500 to £417.

The difference between the two is now £168, £24 per month higher than the basis you assumed when starting your savings plan. So what you should do is raise your monthly saving to £168. That still leaves you a net £15 per month better off.

And £168 per month earning an average 5% a year is what it takes to produce £100,000 at the end of 25 years. Increasing your savings plan contributions when interest rates fall is the only way to be sure you stay on a level footing with a capital-and-interest mortgage

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You can simply assume you have the right level
In practice, if the drop in rates comes after a couple of years, you'll have to work out the capital-and-interest repayments required over the remaining mortgage term, which will be less than 25 years.

You can see from this that if you have a variable-rate mortgage, you can't just blithely assume you've got things sorted by making one decision at the start (that was another mistake the low-cost endowment mortgage buyers made). But reviewing things every time interest rates change is a bit of a pain.

That's why I think the interest-only mortgage-plus-savings plan works better with fixed-rate loans, when you only have to review the whole thing every time you re-mortgage - in my case, every five years or so.

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What's at stake?
Back in the 1980s, people who had used endowment mortgages ended up with surpluses of 20% of the amount they owed on their mortgages. It could happen again.

Assume you earn a higher average annual return on your savings plan than your loan. Then on a £100,000 mortgage over 25 years, my strategy would deliver a surplus of:

- if you earned 2% a year extra, £36,000
- if you earned 3% a year extra, £59,000
- if you earned 5% a year extra, £122,000.<

Now you can see why I regard my mortgage not as a cost but as a profit centre. Happy that it is enabling me to make money out of property, I am even happier to use it to let me make an extra profit out of the stock market.

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Even more reasons to stay in debt
Here are some more reasons why I won't be paying off my loan.

• Remember the old saying about bank managers and umbrellas. Pay money off your mortgage and then, if you need cash, you have to go and ask for it- and if your circumstances have changed, the lender may say ‘No'. Build up money in your own savings plan and nobody can tell you what you can or can't do with it, and provided you keep up your repayments on an existing mortgage, the lender can't withdraw it just because your circumstances have altered.

• By the time the mortgage maturity date arrives, I hope I will have a capital sum larger than the loan and that I will be able to generate annual income from it sufficient to pay the interest. If I can do that, and the mortgage is earning me a profit, why would I ever want to repay it?

• In my old age, I expect my estate will be subject to inheritance tax. So avoiding it will become an issue. Having a loan on my home and passing the same amount of cash onto my heirs will save me (or rather them) a bundle in tax.

When it could be dangerous
Now for some cautions about dealing with your mortgage like this:

• Over any short period, shares may do badly and produce a cash value of your savings plan far lower than what you'd need to have to be in the same position you would have been in with a capital-and-interest mortgage. So if you may need every penny when you move in a few years' time, don't use this strategy.

• Long-term returns from shares are predictable, short-term returns aren't. So don't use this strategy unless you have at least ten years to go to the maturity of your mortgage.

• To get a good return, you need to take an active interest in your fund selections and review them regularly. If you're not prepared to do this, don't bother.

• Be prepared for good times and bad times. Over 25 years there are bound to be some bad times, which might last several years. Remember the stats: stick with it and you're almost certain to win.

Article produced by EveryInvestor.co.uk