fund strategies finds that debt repayment can beat investments
Paying back debt is the best risk-free, high yield investment available, according to Tom Elliott, strategist at JP Morgan Fleming.
He said that while advisers might not get any commission from offering such advice, it would help maintain the trust of clients still smarting from the fall of the technology, media and telecoms supernova of three years ago.
Speaking in Investment Week's sister publication Fund Strategies, Elliott said: 'There are no risk-free savings products that offer a higher yield than the interest charged by credit card companies or the standard mortgage interest rate. The credit card or mortgage rate is the effective hurdle rate for any investors. Anything that delivers a lower annual return is a worse option.'
Taken at random to illustrate the argument, the Halifax building society charges 5.8% for its Variable 1 mortgage. This hurdle rises for taxpayers because alternative savings products produce income that is then subject to tax. For a 40% marginal rate taxpayer, any other investment must produce an income of more than 8.1% in order to be more attractive than repayment of a 5.8% mortgage. Include in the calculation the capital gains tax suffered by many alternative investment categories, and the benefit of mortgage repayment is even greater, Elliott said.
However, he stressed investors should not be focusing entirely on mortgage repayment because of the difficulties of getting the money out again should this prove necessary.
In addition, if investors are seeking capital gains, early mortgage repayment will not deliver them.
'Of course,' he added, 'the disadvantage of early repayment is that the traditional mortgage is an illiquid form of saving. It can take six weeks, often with added charges, to reverse the process and remortgage if you want the money back. In times of unemployment, or when income cannot be guaranteed, a remortgage may be done on very unfavourable rates'.
Although current stock market conditions may convince investors they should seek relative security at the expense of returns, Fund Strategies research shows the savings made from paying off part of a mortgage, for example, can yield a similar or greater return than investing in gilts or cash.
Considering two 25-year term flexible mortgages of £100,000 and £300,0000, we have worked out the amount of money an individual will save if £20,000 is used to repay part of the mortgage after both five and 10 years.
If an individual repays £20,000 of a mortgage after 10 years of the mortgage, for example, the savings will be £28,002 on the £100,000 mortgage and £27,540 on the £300,000 one.
In order to make a more traditional investment worth the corresponding risk, markets would have to return more than this amount. Over 15 years, for example, an investment would need to produce growth of 37.7% to be a more attractive home for the original £20,000.
Although it could be argued that a 37.7% return, or £7,540 gain, is not particularly impressive over 15 years, it must be remembered that the original sum is not being invested but rather used to reduce debt.
For a full treatment of this issue see this month's Fund Strategies.
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