Why you should repay your mortgage early

Finance & economics | Buttonwood Feb. 18, 2025, For the first time in decades, the arithmetic suggests settling housing loans

The holiday from reality, for the happy few enjoying it, has been delightful. Three years ago it was still possible to fix a mortgage rate in Britain and much of the euro area at somewhere near 1%. American housing loans were dearer by just a percentage point or two. Even as interest rates have risen and borrowing costs for new mortgages have doubled or tripled, homeowners who locked in the enviable rates of the early 2020s have been living blissfully in the past. Moreover, the inflation that prompted rates to rise has bitten chunks out of the real value of their debt.

Alas, the holiday is now over for many. Although American fixed rates often last for decades, most in Britain and swathes of continental Europe expire after five years or less. It was in early 2022 that the last of the dirt-cheap loans disappeared, after which borrowing costs began climbing fast. A large number of mortgage-holders, in other words, have either seen their interest bills rocket recently or will do soon. For those with spare cash to hand, a question that seemed remote a few years ago is suddenly a great deal more pressing. Should they repay the debt early?

To many who owed money during the 1980s, when interest rates soared into the double digits, the answer is an obvious “yes”. At the time, borrowing costs became so elevated that merely meeting them, let alone repaying any capital in addition, was a constant struggle. The risk of that being repeated is simply not worth taking. Better, then, to pay all debt off at the earliest opportunity, while doing so is still possible. Even if rates stay where they are at present, that will save money on future interest bills.

Those whose experience was shaped by more recent decades might feel rather differently. Interest rates have spent most of that time on a downward trend, culminating in the ultra-loose monetary policy seen during the covid-19 pandemic. Next to that, it is the hikes of the past few years that look like an aberration.

More important, the opportunity cost of repaying a mortgage has outweighed the potential savings for years. This is especially obvious to those who fixed near 1% before 2022, then watched as the rates on simple bank accounts rose to several multiples of that. Under such circumstances, overpaying a mortgage, rather than depositing the cash and pocketing much more interest than repaying would have saved, would have been nonsensical.

The opportunity cost over the longer term, and considering the alternative of investing in shares, has been greater still. Twenty years ago mortgage rates in Britain were not much higher than they are now, at around 5%. Even with a once-in-a-century financial crisis looming, buying stocks rather than making early mortgage repayments would have paid off handsomely. Since the start of 2005, measured in pounds sterling, the MSCI World share index has generated annualised nominal returns of above 10%. Had your mortgage rate stayed the same for the next two decades (though in reality it would have fallen), paying off £1,000 ($1,250) in 2005 would have saved a respectable £1,800 in interest. Investing it in a global share-tracker fund would have made a profit of £6,500, however.

Today’s mortgage-holders must ask whether such stellar stockmarket returns are still on offer. Those enjoyed by Britons have been flattered by a steep fall in the value of the pound, which has boosted the gains from foreign shares as measured in local currency. For investors around the world, a hefty proportion of recent decades’ high returns has come from ballooning stock valuations. Twenty years ago, for example, the price of the MSCI World index was 22 times as high as its companies’ long-run average earnings. Now that multiple has risen to 30. Put another way, a big share of the gains came from sentiment rather than earnings. Unless investors continue to assign more and more value to each dollar of corporate profit, such a multiple limits the scope for future outsize returns.

As a consequence, repaying your mortgage early looks more attractive now than it has in a very long time, even including those periods when interest rates were at today’s levels or higher. That is an odd thought for central bankers, so long after they started tightening monetary policy to quell inflation, and with many of them having spent recent months loosening it instead. Borrowers who were sufficiently shrewd, or lucky, to secure ultra-low rates for decades rather than years will be enjoying their holiday for some time to come. For plenty of others, reality beckons

Posted: to Wealth Management News on Thu, Feb 20, 2025
Updated: Thu, Feb 20, 2025