This question came to my mind just after I and my wife had agreed to buy a house in London. The sale didn’t go as expected, but the question got stuck in my mind as if I’d bought it. “Should I pay down my mortgage or invest?”. Had we bought the place, what would we do with some spare cash every month?

Although this sounds like a “problem”, it is in fact, a very good situation to be in. Not only we have enough money to cover the mortgage payments but we also enjoy some extra cash every month. So if you’re in this place too, congratulations! We both are a step closer to financial independence.

There are two sides to this problem. The pure mathematical side and the psychological side. And because I’ve always trusted the numbers in my life, let’s start with that first!

Here’s a hypothetical scenario:

Mortgage details

Property cost: £300,000

Current retail-bank interest-rate: 2.3%

Outstanding debt: £150,000

Spare cash to invest or overpay: 20,000

Option #1 – Put all your savings towards paying off your mortgage

Let’s say you decide to put all your £20,000 towards your home equity. You call your bank and make a bank transfer the next day. This reduces your outstanding debt to a total of £150,000 – £20,000 = £130,000.

By saving £20,000 of debt, you have effectively saved £21,189 over a 5-year period if we add the interest in. Great! We saved money that would otherwise go to the bank.

Profit made over 5 years: £1,189

For the sake of the experiment let’s say that the bank will not charge you a fee for overpaying. My previous mortgage would charge me a fee for paying more than 10% of the outstanding loan every year.

Banks are obviously not charities and these £1,189 we have just saved is taken from the bank’s wallet.

Option #2 – Invest the extra £20,000

Let the mortgage run as is and invest the £20,000. Different investment options are buying a property, buying shares in the stock market, or peer-to-peer lending.

According to the historical average of the US stock market, we can get a 7% return. Of course, this may vary from year to year and after accounting for fees. For example, the last 5 years were very profitable for the stock investor (16.82% annualized) but we all know what happened in 2007-08.

Now don’t get me started about your uncle that lost 30% when picking bad stocks 2 years ago…. Or people that have doubled their wealth in 2 years. That’s like playing the roulette.

This is why we take the average. By the way, the past 10-year average, including the financial crisis period was ~7%.

So our £20,000 invested in the stock market for 5 years would return a total amount of….. £28,051.

Profit made over 5 years: £8,051

So should I pay down my mortgage?

The maths say no. But numbers do not tell the whole truth. They have not accounted for the psychological burden of having a debt, a possible increase in interest rates, taxes on investment profits and one’s ability to invest.

Also, I haven’t met a single person saying they feel bad about paying off their mortgage. It just feels good! The following questions make it easier for us to decide.

Do you have a more expensive outstanding debt?

If yes, you should treat the high-interest debt as an emergency. Not an emergency, AN EMERGENCY! This 17.99% interest debt is seriously damaging your wallet and should be cleared off ASAP.

Forget about mortgage overpayments and investments and focus all your efforts on paying off this debt. A good way to start is to switch your mobile plan to £5.56 per month and to earn some side income if possible (try matched betting?).

What type of personality are you?

If you’re risk-averse then you probably find paying down the mortgage a better option. There is a psychological burden coming with every debt, and a great relief and sense of achievement when you repay the last cent. Some people – understandably so – prefer to be debt-free. There is no greater feeling than owing nothing!!

Talking about risk… note that paying down the mortgage gives you a GUARANTEED return of 2.3% (or whatever the interest rate is). There is no risk involved, no dealing fees to think about, no chance of losing a PENNY, whatsoever.

Investing, on the other hand, involves some risk. Sure, the risk can be reduced if you see it as a long-term game and you may even get back more than the expected return, but it’s all volatile.

If the stock market crashes and your extra cash is cut to half, will you still be able to pay the mortgage repayments or will you go into trouble? Are you going to remain calm when you see your wealth potentially cut in half? Even if you know that in the next 5 years it will grow back higher than the initial amount?

If you answered no to these questions, then maybe paying down the mortgage is a better option. Otherwise, you also risk becoming a victim of your own behaviour. That means, selling your investments out of fear when the worst happens (instead of buying more!) and never touching investments again.

If you’re like me and cannot care less what the stock market does because you know it’s going up in the long term then investing may be the best way to go, given the ultra-low interest rates. In fact, you should not watch the ups and downs that happen every day in the stock market. This saves the human error of wanting to “Get in and fix things” which usually ends up badly. Why? Because of our flawed human psychology, fund costs when selling/buying, capital gains taxes, and commissions. More about that on another article.

So, if you have a good savings rate and are comfortable enough with covering your mortgage in a financial downturn then going for option #2 is better.

This is why this question depends entirely on one’s circumstances. It’s not a black or white answer.

What about those taxes?

The £8,051 profit from investments may not be tax-free. If you invest those in a tax-free wrapper like a UK Stocks & Shares ISA then yes, they are. But there’s only a certain limit up to which you can invest in these wrappers. As of April 2017, this will be £20,000 per year for each person.

Usually, people having a surplus may need to pay tax on the gains (Capital Gains tax plus some Dividends tax). Therefore, if you have hit the annual allowance of £11,100 (because you’ve sold other assets like your car) you’ll pay tax on top of that.

The £8,051 will be cut to £6,822 for someone with total income up to £32,000 (18% CGT tax), and if the job income plus gains exceed £32,000 then it can go as low as £6,289! Luckily, there is a £5,000 dividends allowance before we pay tax there too.

That’s something worth considering, given that the debt you can save from paying off your mortgage is tax-free!

So maybe you want to fill-up those tax-free ISAs with investments and then contribute the rest towards your mortgage repayments.

Are interest rates going up?

If interest rates have an upwards trend then you know that you will be gaining more if you pay down your mortgage. This is simply because your debt will become more expensive overall.

Skeptical readers should really challenge me here. Who knows where interest rates are heading? Trying to predict this is like trying to predict the stock market, which we already agreed is a very expensive hobby to have.

But if interest rates are high enough, for example at 6%, then paying down the mortgage may relief some pressure.

Are you contributing to the basics?

Every person should have a pension and an emergency fund.

Are you contributing to a pension? If not then the surplus cash is actually more than £20,000 if you use it towards pension contributions. That’s because you pay less tax if you contribute more to your pension. How cool is that. Pension contributions are a great tax incentive and it makes sense to contribute there if you aren’t already.

The other basic need is to have an emergency fund for… you know… emergencies. I’m keeping a 3-month salary in a current account because if my house catches fire, I lose my job or something – touch wood – I want to be able to live off of savings until things become stable again. If you’re living paycheck-to-paycheck, stop buying lattes and accumulate an emergency fund first.

Thoughts?

Never be afraid – action beats inaction every single time. This is what I tell myself whenever I get stressed about something. Then when I take action and even when it’s not a perfect one, I always feel better. So choose a path and take action!

Mortgage overpayments seem to be the safest option but not necessarily the one that pays better. Knowing myself, I’d put the money to work hard for me by investing as long as the interest rates are low. But although investments come with higher returns at the moment, they have their short-term bumps.

Everyone’s situation is different. What about yours?