Interest rates, which were already low, have dropped further since the coronavirus outbreak. With stock markets also falling drastically, this has led people to question whether it is better to buy shares or to overpay their mortgage.
Ultimately, it comes down to compound interest.
Overpaying your mortgage
In March, the Bank of England cut the base rate to 0.1% to address the coronavirus crisis. High street banks often use the base rate as a reference point when setting their interest rates for savings accounts, loans, and mortgages.
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For savers, money held in their savings accounts or Cash ISAs is likely earning them even less than it was before. For borrowers, this means that interest on loans will probably be lower.
Your mortgage payments might have dropped slightly in the past month. You be wondering whether you should just continue paying the same amount as before or do something else with the extra cash, like buying shares.
Small change
The cut in the base rate from 0.25% to 0.1% might seem minimal. However, over a long period, this could make a huge difference to a person’s wealth. Albert Einstein allegedly called compound interest the eighth wonder of the world: “He who understands it, earns it. He who doesn’t, pays it.”
Compound interest is literally when interest is earned on interest. The thinking goes that if you overpay your mortgage, you will be reducing the amount of the outstanding mortgage, which cuts the compound interest working against you.
When presented with this scenario, I like to flip it on its head. How can I get compound interest to work for me?
Buying shares
With the recent stock market crash, many shares in the FTSE 100 appear to be trading at a price below intrinsic value. In the past year, the index lost over 22%.
By comparison, at HSBC, a two-year fixed standard mortgage with a 90% maximum loan to value and maximum loan value of £400,000 currently attracts an initial interest rate of 1.79%, followed by a variable rate of 3.54%.
On the face of it then, overpaying your mortgage last year might have been better than buying shares, as the FTSE 100 lost money.
However, this does not show the whole picture.
Looking back over the past 30 years, a term of some mortgages, the FTSE 100 has returned roughly 150%. We can see then that investing in stocks and shares is a long-term game. The successful investor needs to be thinking about buying and holding for decades.
My fellow Fool, Rupert Hargreaves, notes that if you bought a FTSE 100 index fund during the financial crisis, you would have seen a return of roughly 9% per annum on your holdings to the start of March.
People who buy shares now will be hoping to benefit from the market’s likely recovery.
To me, the possibility for returns in what looks like an undervalued stock market far outweighs the benefit of paying off a mortgage at current interest rate levels.
I would rather have compound interest working for me, which is why I am buying shares.
