Which mortgage do you repay first? It might NOT the one with the highest interest rate…

low-interest-rate-mortgage-loan-800X800I was in discussion with an old friend of mine the other day about our financial plans. We’re both very interested in personal finance and have both dabbled in Buy To Let property – with different strategies, but both with reasonable degrees of success

He was explaining to me how well he was doing overpaying his buy to let mortgage. I asked him why he wasn’t overpaying on his personal mortgage instead, to which he replied “the interest rate is slightly lower on my personal mortgage”

Conventional wisdom indeed dictates that you pay off your most expensive debts first, but I disagreed with his approach in this instance. I wasn’t able to convince him, so I went away and did the maths. What I was struggling to explain to him was the bigger picture around tax deductible expenses. Currently in the UK, interest payments on a buy to let investment are allowable business expenses and so it might be more efficient to repay your personal mortgage first, even if the interest rate appears to be lower

(This exercise actually led me to a personal view that I’d be happy to NEVER PAY OFF MY PERSONAL MORTGAGE EITHER, but more on that further below…)

Here’s an example:

Interest rate Amount borrowed Interest pa Interest pm Interest net pa Interest net pm
Personal mortgage

3%

£100,000

£3,000

£250

£3,000

250

Buy To Let (BTL) Mortgage

4%

£100,000

£4,000

£333

£2,400

200

-£1,000

-£83

£600

£50

Looking at the monthly payments, my friend is seeing that his BTL mortgage interest is over £80 per month higher per £100k borrowed, so I understand his objection completely. However, when you get to file your tax return the picture changes. As a 40% taxpayer he could reduce his taxable earnings by £1,600 per year in this example, meaning that after he claims his allowance, the higher interest BTL mortgage is actually £50 cheaper per £100k borrowed every month!

As the interest rate difference grows, this changes and it becomes increasingly attractive to pay off the BTL mortgage first (in the above example if the BTL interest was 5% then both net figures would be the same), especially when you consider that you are better off right now in cash terms, rather than waiting until a year later to file your tax return and get your money back. However the point is that it is worth doing the maths

Now let’s stretch this principle yet further.

I’m in a place where I’d actually go a step further than this. Not only will I refrain from paying off my BTL capital, I don’t think I’ll ever pay off my personal mortgage either for 2 reasons:

1. I can usually make money earn more net interest than my mortgage rate costs

The mortgage on my principal residence has had an interest rate of less than 3% for some years now. Interest rates on savings are even lower, even before tax is taken off, so I couldn’t save at a better rate than my mortgage. But I do have faith that despite some massive falls and enormous volatility, the stock market will exceed 3% net over 25 years, hopefully by a much greater margin. And so although we have recently reached a point where our stock market investments (nearly all in managed funds) in tax sheltered ISAs have now exceeded the amount of our mortgage, I simply could not bring myself to take this cash out of the stock market to pay off a very low interest loan, especially as I would lose the tax-exempt status of my investments

Obviously when interest rates rise I’ll review the position but as long as there is an investment vehicle (property, stocks, bonds, savings interest) that can return more than the mortgage interest I will not repay it until I really have to

2. Gearing / Leverage

Despite very limited property capital growth over the past few years, I love the idea that one day, my properties may increase in value. When they do, I will see accelerated capital growth too. For a £100k property with a £70k mortgage, I would have £30k tied up in equity. If the property were to rise in value by 10% to £110k my mortgage would stay the same but my equity would rise to £40k. This is a rise in equity of 33% for a 10% rise in property value

I believe accountants call this “gearing” or “leverage”. Critics will say I am borrowing money against my home to speculate on the stock market, and that it is irresponsible to take such a risk, as any reduction in property value has an accelerated downside (a 10% fall in property value would reduce my equity by 33% too). Myself and a fair few personal finance bloggers refer to it as “good debt”, although I am still surprised quite how many personal finance bloggers’ primary goal is still to repay their mortgage. Perhaps it’s a feel-good thing…

This isn’t financial advice (please read my disclaimer), but what do you think? It’s crucial to my early retirement plans, have I missed anything?

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