One of the great F.I.R.E. mantra’s is ‘pay off your debts first .. get rid, get rid, reduce, eliminate … etc etc . They are a drag.
Well totally agree, but I never quite viewed our mortgage the same way. The cost of most debt ranges from a really cheap 4-5% loan to 100%+ credit cards. The monthly interest matters as it is high and adds up. But our mortgage was 1.04% and has now been reduced to 0.79%. and we have two chunks totalling just under £62K.
Just to put this into context, the calculated total interest for the remaining 6.5 years will be £1,639 … or an annualised rate of 0.4% on the current principle …. peanuts !
So I naturally assumed that keeping capital invested and growing at a conservative rate of say 5% would obviously yield me a far higher net value.
Well…. I was wrong …. and he is why !
(Skip to the Conclusion if you just want the answer)
Some Basics and the Numbers
We all know how to calculate long term return on a lump invested – just basic compounding:
So not paying my mortgage off and taking money out of my SIPP (Self Invest Private Pension) that is taxable I can work out the gross impact on my SIPP fund:
Again .. all very easy and straightforward. But the bit I never considered was the long term impact on my pension fund, ie how much it was reduced as a consequence. Now I was (and should be again for other reasons) at a point where the fund well exceeds requirements so do I care ? Well, we have had a correction of knocking on 30% and will likely get another 20-30% drop as markets wake up to the reality that it will not be business as usual come June/July and corporate earnings for the year will be well shot. So, yes .. right now, I do care.
The thing to not forget is the lost opportunity return on the money drawn out of the pension fund. You take £10K out one year and the return is say 5%, you loose £500. In year 2 you loose £550 and so on – compounding !!
One other factor that changes things and has prompted me to think wider is that I should be getting an inheritance in the next few months from my late mum’s estate. Monte Carlo lifestyle not on the cards but a tidy sum that funnily enough covers one of the ‘cash bucket’ questions some like to comment on – how much do you need to cover for a correction…. well .. it will be more than enough thanks mum xx
So lets look at the numbers in more Detail
Setting the scene, I have two mortgage lumps, one small and one bigger. I will aim to keep the smaller one (only about £9k outstanding come October when I would be able to do this. Repayments are small and as we run no other debts (not even credit card), it works well in maintaining our credit rating. So the capital sum to pay off will be a little under £50K.
After finalising mum’s estate, maxing out tax free funds etc, I am just going to pick a flat number available for illustrative purpose of £150K.
My two options are then:
- Invest it all and keep paying the mortgage ( £8.4k pa for 5 years and £7.9k final year)
- Pay of the mortgage and just invest £100k
I am just going to assume a flat post fee return of 5% for my fund and pension calculations. As the investments will be outside of tax free status I will get taxed on returns. (Funnily enough if I assume 2-3 years of much higher growth to cover for the big market upswing then the figures look even better !)
It is a tad complicated, but there is a Capital Gain Allowance (CGC), a CGC tax of 10% for basic rate and 20% for Higher rate and a dividend tax of 7.5% and 32.5% respectively. I will aim to remain in the lower bracket, but may have some overspill, so a round aggregate tax rate of circa 20% is probable (or very close) and as this is the same as the tax rate for my pension fund it feels a real like-for-like comparison
What I will consider is the point at 6 years when the mortgage is paid off and then a further 9 years (taking me to the age of 70), then extrapolate off to say the age of 90.
What I see is every year there is a positive net benefit to paying off the mortgage and at the age of 70 the value is just over £25K. Not massive but not to be sniffed at either especially as I did not expect this at all.
But the bit really missing is the impact on future income, ie what I cannot take out of my pension (safely) as the fund is lower:
Just using a ‘standard’ 4% assumption I loose an annual income of circa £4.6K and rising. Arguably more as at age 70 I will likely be able to take rather more than 4% if I chose. Even in 6 years after the normal mortgage period the lost income would be around £3.1K.
If I really extrapolate the cumulative lost income it totals over £44K….. astonishing … but only because I never considered the impact on my pension fund
And what of beyond 70 ?
Well I can safely assume I can take a withdrawal rate of 6% from 70 and increase this by a nominal inflation figure of 2%.
Unrealistic as we use less when getting older, but again just to illustrate effects without changing too many variables
Well a quick summation shows a net positive additional income starting at around £1.9K and rising to just over £10K by 90, but a lower overall net funds value. Why ? – well simply put it is the compounding effect of the lost Pension Fund Opportunity Income.
Remember – it is not the size of the combined funds that really mater’s, but the income stream that can be reliable withdrawn
Happy to take that !!
Much to my surprise paying off the mortgage at its paltry rate gives a higher overall net benefit. This would be the same for any large debt. By considering the actual Pension Fund impact, ie, that it depreciates, I actually get a far truer picture. The headline will always be the ‘fund size’ as that makes us feel wealthy. Just look at the graph above and see the relative difference in funds (although they do depreciate to near the same point by the time I am almost certainly dead).
It is however the relative increase in come that is more important. Who cares if the fund is £200K or £500K. That only really matters if you care about inheritance. What matters to us is income streams and a cumulative EXTRA income of over £100K from the age of 70… just by paying the mortgage off 6 years earlier…. now that did surprise me !
- Don’t assume that as a mortgage may have a much lower interest rate than an investment can earn it does not act as a fiscal drag
- My working assumes that mortgage payments come out of my pension fund (as I retired), but if working and can cover the cost through pay the balance changes … go work out the answer (I know the result, but that is just me)
- Golden FIRE rule shines bright … PAY YOUR DEBTS (all of them) OFF AS FAST AS POSSIBLE