High debt levels only make sense in a high inflation economy. There are many reasons for this but as a general rule when inflation is low (as it is now) then it makes great financial sense to reduce your debt levels as much as possible. The best way you can do this is to overpay your mortgage.
The theory goes that if you take out debt when inflation is high the size of your debt actually decreases in real terms over time, all other things being equal. Lets assume i take out a £100,000 mortgage loan and inflation is running at 5% per year. Assuming house prices do not increase in real terms, in one years time your £100,000 house would be worth £105,000. In five years this would be worth £127,628. You can see then that your £100,000 of debt has got you an asset (the house) that is worth £127,628. Of course everything else would have increase in price/value over this time (wages, cost of food etc), except your £100,000 mortgage.
When inflation is low (like it currently is) this effect disappears and you rely purely on the housing market rising, not the economy becoming inflationary in order to increase the value of your asset compared to your debt. As we have seen in recent years house prices do not always rise.
In addition to the above effect high inflation will mean your wages increase faster. This should allow you to pay off your debt quicker than if your earnings were not increasing at a faster rate. Again in the above example after five years your wages would have increased by 27.6% while your debt remained at a notional value of £100,000, therefore reducing the proportion of you income that goes on servicing your debt.
The reverse of the above is true. In a period of very low inflation like we are currently experiencing the real value of your debt does not decrease naturally over time. Therefore it make much more sense to reduce your debts as quickly as possible. For most home owners the most effective way of achieving this is to overpay their mortgage.
Take Advantage of Low Interest Rates
Assuming you are not on a fixed mortgage deal, low interest rates generally mean your mortgage repayments are lower. This means you should have more disposable income left each month which you can put towards repaying the capital on your mortgage sooner. By reducing the capital additionally each month you reduce the amount of interest you would have paid each month going forward. This can save you literally thousands over time as we explained in our last post where we showed how to save £21,000 on your mortgage by overpaying a small amount each month. The more you overpay the more you save and the quicker the mortgage gets paid off.
Can you afford repayments if interest rates increase?
Considering moving? After the recent credit crisis mortgage lenders now want higher deposits when offering new mortgages. In addition despite interest rates being relatively low, mortgage lenders are charging higher interest rates than they were before the crisis. That is to say that a couple of years ago in the UK it was possible to get a tracker mortgage that charged just 0.47% above the Bank of England Base rate. The very same mortgage now charges 2.75% above the Bank of England Base Rate.
What does all this mean? Well if at some point in the future you will be moving you’re going to need a new mortgage deal. That deal will most likely be relatively more expensive when compared to your current mortgage deal. In addition you’ll also need a bigger deposit to in order to get the best deal. As a result it makes a huge amount of sense to ‘make hay while the sun shines’ and take advantage of you current mortgage deal and low interest rates to overpay as much of you mortgage as possible. When you do come to move home and remortgage you’ll need a much smaller mortgage making it more affordable for you.
Over Pay Your Mortgage & Retire Early
Who doesn’t want to retire earlier? By overpaying your mortgage regularly, it is very easy to pay off your mortgage many years earlier than planned. If you no longer need to work to pay the mortgage then you may well be in a good enough financial position to take an early retirement. If you want to retire 10 years early then maybe you should consider starting to over paying your mortgage now.