Interest savings - overpay mortgage, or invest??

[j26]

When the interest rate cuts finally come through (I'm looking at you AIB) my mortgage will fall by about 120pm (ish).

We are used to paying the current level of mortgage, and I was thinking of overpaying the mortgage by the amount of the saving in interest to reduce the term, but I was wondering if there is a better option.

Since share values are so low at the moment, would it be worthwhile to invest the money in a unit linked fund? When the recovery eventually does take place (in a year or two or five or whatever) it should provide a better return than the interest saved by the overpayment, and should knock a sizeable chunk off the mortgage. Even if shares stay low for a few years, it means that I'm buying units at a low price, and eventually when the recovery comes, I'd benefit even more.
I'm aware interest rates can rise, wiping out the saving, but the thing is that I can stop payments if necessary, and just leave the fund there, or pay it off the mortgage whichever option looks better at the time.


So, good idea or bad?

 

[LDFerguson]

The question of whether is it better to pay off a mortgage or invest is a popular one, but one to which there is no definitive answer suitable for all. In simple mathematical terms, if you are paying an interest rate on your mortgage of 5%, this means that you are paying interest to the lender of 5% of the amount owed, each year, although often interest is calculated on a daily, weekly or monthly basis.

So by using capital to reduce or even completely redeem such a mortgage, you are saving the 5% annual interest that you would otherwise pay. So in a manner of speaking you are getting an effective return of 5% on money you employ to do this. In the long-term, the rate of interest on a mortgage would be expected to be greater than the rate available on deposit, so if you don’t require access to your capital it is preferable to pay off a mortgage than to leave you money on deposit for an extended period.

However, paying off your mortgage is not a very accessible way of investing your money. If you need to access your capital, you will need to either apply for a new loan or sell the property. In addition, tax relief on mortgage interest must be considered as it reduces the effective rate of interest you pay on any mortgage.

It is possible to invest in a variety of Managed Funds which are likely to produce a return greater than prevailing mortgage interest rates but none of them will guarantee to do so. You have to be prepared to increase your level of risk. Investing in alternative funds may provide a greater return; it may not – indeed the value of your investment may fall as well as rise. In summary if you are prepared to accept a higher level of risk in return for the potential of higher returns over the medium-to-long-term, you should invest elsewhere; if you want a more secure rate of return that is nonetheless greater than bank deposits, you should pay off your mortgage.

 

[Askar]

You could also consider doing a bit of both i.e. some capital prepayment and some investing. If you have an AIB tracker of ECB+0.6 you can write to them and fix it at a level which involves some capital prepayment. The remainder can go into a regular saver account and be used every quarter or so to purchase ETFs or into high cost unit funds (I include 1% annual charges on buying indices in this category). Unfortunately, there are no low cost unit funds available to retail investors in this country.

 

[j26]

Thanks for the replies.

I was looking into it a bit further.

the AIB Parent saver plan is currently 10% but is guaranteed at ECB + 6% (ECB + 4% after May 2009) and my mortgage is ECB + 1%. Even allowing for DIRT I can exploit that gap in rates, and pay a lump sum into the mortgage annually once the money reverts to the lower level. Obviously the other option is to invest in equity with higher risk, but potentially better returns.

The only question remaining is the level of risk I'm willing to assume. I have other investments with various levels of risk, so do I want to take on more, and that's really just a personal question for me. Hmm.......