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Financial independence: How to calculate the capital and contributions you need in your ISAs and pensions post image

This is part five of a series on how to maximise your ISAs and SIPPs to achieve financial independence.

Welcome retirement fans! We’re now at the pivotal point on our journey to maximise our ISAs and pensions to achieve financial independence (FI). Together we will walk through the calculations that’ll enable you to create a robust plan to power you towards a happy independence day.

The story so far:

  • Part one set out the FI problem of retiring early using UK tax shelters.
  • Part two explained why personal pensions beat ISAs later in life.
  • Part three revealed the core principles when balancing your ISAs versus your pensions.
  • Part four showed how to choose a credible sustainable withdrawal rate (SWR) to fit your situation.

Like an excitable schoolgirl hoisting her hand in class and insisting “pick me, pick me!”, part five has now arrived on the scene to illustrate the sort of FI calculation you’ll need to do, via a simple case study.

We will cover:

How to calculate the amount of capital you’ll need to have in your ISA portfolio to sustain you until minimum pension age.

The monthly investment savings that’ll put you on course to hit your target ISA figure.

The same calculations for your pension so that the total portfolio should last for the rest of your life.1

These calculations will account for your income, spending, the riptides of the UK tax system, the dangers of withdrawing from a retirement portfolio, and maximising your tax shelters.  It will incorporate pragmatic expected investment return assumptions.

Let’s first survey the tax battlefield on which this game is played.

Income layer cake

This is the income tax and national insurance situation for an employee living in the UK (except Scotland) and earning up to £100,000 per year.

My apologies to the self-employed, Scottish income taxpayers, anyone earning over £100,000, and all others whose position varies from the above.

It’s important we navigate just a section of the tax maze initially, so we can establish some guiding principles. We can build out case studies from here, or you can customise the calculation to your own circumstances. The Low Incomes Tax Reform Group has produced an excellent summary of the broader UK tax terrain.

The income layer cake is useful for spotting things that are often overlooked, such as basic rate taxpayers pay 32% tax on income when you include National Insurance Contributions (NICs). Higher rate taxpayers pay 42% tax on income.

Basic rate taxpayers have, at most, £25,500 net income available to max out their ISA, without even looking at the demands of living expenses and pensions. I appreciate I’m skipping a boatload of exceptions – trading allowance, property allowance, dividend allowance, marriage allowance, child benefit, personal savings allowance, student loans, Scottish income tax variations… [loses the will and dies].

Okay, I’m not dead but I’ll soon wish I was. Let’s combine the income tax layer cake with a simple case study to illustrate our FI calculation. Enter an aspiring millennial FIRE-ee known as The Agglomerator.

This young upstart wants to hit FIRE as soon as possible without living in a caravan. The Agglomerator boasts these FI vital statistics:

  • Annual salary: £60,000
  • Other income: £3,000 pension match (Up to 5% of salary)
  • Salary sacrifice: Yes, but paid employee NICs only
  • Living expenses: £20,000
  • FI net income required: £20,000
  • Existing assets: £0
  • Age: 30
  • FI in: 16 years
  • ISA bridge to pension: 12 years
  • Minimum pension age: 28 years’ time when age 58.
  • State Pension age: 38 years’ time when age 68.

Here’s The Agglomerator’s income layer cake showing how much he will contribute to his pension and ISA, after expenses and tax. (Scroll the spreadsheet to the right for the full shebang.)

The full 5% pension match is claimed, of course, but all of The Agglomerator’s higher rate earnings are protected from tax by being herded into the pension.

The Personal Allowance is completely absorbed by living expenses.

There’s £22,287 left per year from Basic rate tax band earnings after pension contributions. More than one-third of that goes on living expenses, and the rest takes cover in the ISA.

Nothing is left for taxable investment accounts (GIAs) or Lifetime ISAs (LISAs).

Tax paid is £10,952 (It’d be £16,666 without any tax relief). The Agglomerator’s average tax rate is 17.38%.2

You can verify your own tax obligations with a friendly tax calculator.

The Agglomerator invests £32,000 annually – split into:

  • £14,323 ISA contributions.
  • £17,724 pension contributions.

That contribution level will get The Agglomerator to FI in 16 years providing he can stay off the avocado toast

You can’t live on £20,000 a year? What’s wrong with you, you clown car driving, latte sipping snowflake? Want to retire and use central heating do you? Pah! MMM is going to punch your face off!

Excuse me. Wrong audience. Sure, this case study is going to differ from your own situation in a ton of ways, but the basic principles can be bent into your shape.

The ridiculous assumption I’m making is no promotions or side-hustles during the entire 16 year FI run, despite the fact that The Agglomerator is a determined, young go-getter with plenty of skillz. (I believe in that guy!)

Also, this is a meal for one. Two can usually live more efficiently. Although I suppose there’s always the danger that two becomes three then four…

FI calculation here we come

The key variables are:

  • How much do you need to live on?
  • For how long?

From here, we can play around with our investment contributions, saving period and expected returns to solidify our numbers.

The Agglomerator needs £20,000 to live on.

He guesses that he can build his portfolio to FI critical mass in 16 years. His raw FI numbers look like this:

Withdrawal age: After 16 years The Agglomerator will be 46 and living off his ISAs. He can access his workplace/private pensions from age 58.

Portfolio duration: his ISAs must last a minimum of 12 years from age 46 to 58.

The total portfolio must last until his clogs pop. Life expectancy data suggests that from age 46 The Agglomerator could keep on trucking for over 50 years. If you’re part of a couple, one of you might well last longer. If you don’t kill each other first.

SWR required: This is time dependent, among other things. See our FI SWR table.

  • We’re using the pessimistic green numbers on the table for our case studies.
  • Any time period over 40 years equals a 3% SWR.
  • We also need a separate, time-bound SWR to ensure our ISAs don’t run dry before we make minimum pension age.

The Agglomerator chooses a 6.5% SWR for his ISAs. That figure is a downbeat compromise between the 10-year SWR of 8% and the 15-year SWR of 5%.

Net income required: the amount you want to live on after tax. (The figures used throughout are in today’s money as we assume a real rate of investment return and inflation-adjusted expenses, income and contributions.)

Gross income required: The pre-tax income you need to pay your taxes and your living expenses. That’s not an issue for ISA withdrawals because they’re tax free. Pensions are subject to income tax on withdrawal, and the rate that will apply in the far future is anyone’s guess.

What to do?

We base our gross income calculation on today’s tax regime. Insert your own Tax Rate of the Future, if you prefer. See the Gross income calculation section below for more.

FI capital required:

ISA capital = net income / SWR
For example: £20,000 / 0.065 = £307,692

Total portfolio = gross income / SWR
For example: £20,589 / 0.03 = £686,300

You may well still be drawing some of your income tax-free from your ISAs by the time you hit minimum pension age, but we play it safe and base the total portfolio capital requirement on gross income. This gives us a little wiggle room in case tax-rates worsen or some other factor goes against us.

GIA capital could be determined using your net income, if you’re confident that your account will remain stumpy enough to stay within the bounds of your tax allowances. Gross income is safer but we’ll have to come back to this in the next episode.

Capital required in pensions by the time you FI:

Total portfolio capital minus ISA/GIA capital. For example, £378,608 in the case study.

Monthly investment: The investment contributions wrung out of our income layer cake are poured into an investment target calculator to ensure we can hit our FI capital bullseye in the swiftest possible timeframe.

Investment target calculator

Now let’s turn to the Investment Target Calculator from Candid Money. Other Investment Target calculators are available.

The calculator enables us to dial up the monthly contribution required to hit our FI capital targets. If our various assumptions don’t quite marry up then we can play with the variables a little, especially the saving period and the balance of contributions we make to our ISAs and pensions, as revealed in our layer cake.

The calculator looks like this:

Calculating ISA contributions using an investment target calculator

Target amount = ISA capital figure from the previous table.

Existing investments = Zero for The Agglomerator but you may be in better shape.

Saving period = Estimated time to FI. It’s 16 years in this case.

Annual investment return = The expected real return figure of your portfolio.

We’re choosing the rates of return for FCA prescribed projections. Yes we are.

The FCA’s current expected returns are modest in comparison to the historical averages. Their midpoint projection for equity is a 4% annual real return over the next 10 to 15 years. They offer a range of 3% to 5%.

The midpoint for conventional government bonds is a trippy -0.5%, ranging between -1% to 0%. Safe havens don’t come cheap these days.

Why consult some financial Mystic Meg when your actual returns will assuredly be different from the above? Well, the model needs a returns figure as a ranging shot on the future.

If reality proves worse than forecast then you’ll undershoot, or will need to invest more. Ideally things turn out nice again, and you’ll arrive early.

At the planning stage, our job is to use a figure that isn’t too sunny but doesn’t crush our spirit either. Pragmatism rules. Despair can go do one.

Here’s some alternative forecasts if you don’t like the one I’ve used.

The Agglomerator has a high risk tolerance so we’ll go for an expected return of 4% based on a 100% equities accumulation portfolio and a long-ish 16-year time horizon.

An 80:20 equity:bonds portfolio would give us an expected return of 3%.

(4% x 0.8) + (-0.5% x 0.2) = 3.1%

A 60:40 equity:bonds portfolio would give us an expected return of 2%.

(4% x 0.6) + (-0.5% x 0.4) = 2.2%

Income = Investment income; 0% because it’s included in our annual investment return figure, which is a total return incorporating dividends and interest.

Income paid as = ISA setting because we’re contributing to an ISA! Use the same setting for your pension income, which also grows tax-free.

Annual charge = 0.5%. That’s 0.25% platform fee, 0.25% average portfolio OCF. You can probably do better.

Are you a taxpayer? = Non-Taxpayer as we’re in an ISA. Again, use this setting for your pension as we deal with tax concerns separately.

Annual inflation rate = 0%. Our annual investment return is a real (i.e. after-inflation) return, and we assume that our contributions will be annually up-weighted for inflation.

The result = £1,200 monthly contribution required to hit The Agglomerator’s ISA capital target. Or £14,400 per year.

But you’ll notice he can only squeeze £14,323 out of his layer cake. Can The Agglomerator drum up the extra £7 per month? He mentally resolves to eat a few less pies and then gives the green light to Operation FU.

If the gulf between desire and reality is a little greater, we can adjust.

The main lever to pull is saving for longer. We can reach the same target with a lower contribution level by taking more time.

An 18-year saving period in this case study takes a fair bit of pressure off the ISA bridge. Declaring FI at age 48 means funding a 10-year gap to the minimum pension age. The Agglomerator could then use an 8% SWR for his stash.

£20,000 income / 0.08 SWR = £250,000 ISA capital target

He’d still need £686,300 across the entire portfolio but his pensions would do more of the work in this scenario:

£686,300 – £250,000 = £436,300 pension capital target

The Agglomerator’s pension contributions are far more tax efficient than his ISA contributions, so FI gets easier the more his pensions do the heavy lifting.

You can also calculate your pension contributions in exactly the same way as the ISA example above.

The target amount is your Total Portfolio Capital figure minus your ISA / GIA capital figure.

State Pension and defined benefit reinforcements are covered in the SWR bonus section below.

The maximum contribution you can make into your ISAs is £1666.66 per month or £20,000 per year.

If you need more than that to bridge your gap to minimum pension age then GIAs are the place to turn.

If your ISA bridge is very short then you’d be better off funding it purely with cash rather than a portfolio of volatile assets.3

This is known as liability matching. My cash assumptions lead me to believe that any gap of eight years or less should be dealt with by stockpiling cash. I’ll deal with this in more detail in the next episode but, for now, know that the FCA’s expected real return on cash is -1% per year.

Gross income calculation

Most FIRE-ees will pay income tax on their pension income when it tops £16,666 a year. (More on where I conjured that figure from below.) Our capital target figure therefore needs to take into account the taxman’s slice.

To calculate the gross income required to do this, we’ll use the very nice pension tax calculator devised by Which?.

Here’s the gross income calculation for The Agglomerator, who needs £20,000 in net income per year:

Calculating gross income using a pension tax calculator

Amount you’re withdrawing = Gross income. You won’t know this figure until you’ve played around a little. I just typed my net income into this field and kept upping it until the calculator flashed up the net income result I wanted (in the Total lump sum after tax field).

Lump sum from an income drawdown plan = No. This makes the calculator show the result in the most convenient format for planning purposes. I’ll explain my rationale on this in a sec.

Do you live in Scotland? Well, do you punk? You’ll get results tailored for Scottish income taxpayers if you tick this box.

Total tax you will pay = Amount you chip in for schools, hospitals, roads, police, social security, the military, and so on (seems like quite a good deal).

Total lump sum after tax = The net income you can expect to get, using today’s tax regime, accounting for your Personal Allowance and 25% tax-free cash.

I’ve set the calculator so it shows your tax position if 25% of your income comes from your pension’s tax-free lump sum. That means I’ve set the calc to Uncrystallised Funds Pension Lump Sum (UFPLS) mode.

That’s a mouthful in anyone’s book but the assumption doesn’t mean you have to use UFPLS in retirement – drawing 25% of your income tax-free and 75% taxed, every time you dip into your pot.

Depending on how you use your pension, you could take your 25% tax-free lump sum entirely upfront and invest it all in ISAs and GIAs. If you can tax-shelter that amount quickly enough, and draw 25% of your income from it per year, then the result is the same as UFPLS.

I’m ignoring the present day option to continue to contribute your full annual allowance into your pension, if you choose to take your 25% tax free lump sum only. I’m also discounting the fact that some could probably live tax-free for several years on their lump sum. There are many roads to Rome.

Some commentators will also warn that the 25% tax-free cash could be scrapped by a future government sniffing out bigger tax revenues. Yes, anything’s possible. Please adjust your personal calculation as you like.

My simplifying assumptions give us a rule-of-thumb for how much each person can live on tax-free using pensions:

£1 / 0.75 = £1.333 (how much each £1 of net income is worth after 25% tax relief).

£12,500 x 1.333 = £16,666 (total amount of tax-free income you can draw from your pension including the 25% tax-free amount).

Remember the State Pension is taxed as normal and for the sake of sanity I have to leave lifetime allowance calculations on the sideline for now.

Investment fees and the State Pension SWR bonus

We’re so nearly there. The other big factors are the SWR drag of investment fees once you’re a deaccumulator and the SWR spike you get from the State Pension and any defined benefit pensions that may turn up at various milestones on your FI journey.

The SWR drag of investment fees is succinctly explained here.

Thankfully you only need to subtract 50% of your investment fees from your SWR. This is for arcane reasons best explained via the link above.

My assumption:

That 0.25% deduction would reduce The Agglomerator’s Total Portfolio SWR to 2.75% for a retirement over 40 years. (The deduction also applies to the ISA SWR.)

£20,589 / 0.0275 = £748,690 capital required, instead of £686,300, for a 3% SWR.

Happily we can neutralise this blow with the State Pension SWR bonus.

If you expect your State Pension, or defined benefit (DB) pension, to charge over the hill on the day you declare FI, then just deduct those cashflows from your gross income requirement, and calculate your reduced FI capital based only on the income you need to sustain from your portfolio.

Most of us are not so lucky, except that we have the amazing Big ERN from Early Retirement Now on our side. He’s calculated how much of a bump your SWR gets from an income stream that won’t arrive for many years down the line, like the State Pension.

Read ERN’s piece on Social Security and Pensions for the full lowdown.

Pay careful attention to the part from Introducing: Big ERN’s cashflow translation tool up to What if benefits are not adjusted for inflation?

ERN’s formula also works if you have a defined benefit pension on the way.

I’ve applied ERN’s formula and the first table in his post (Impact of cashflows with Cost of living Adjustments) to The Agglomerator’s case study to simulate the impact of his State Pension:

ERN’s formula requires you to estimate the percentage value of your supplementary cashflows versus your FI portfolio.

The full new State Pension provides an annual income of £8,767. You qualify for the full whack by contributing 35 years of NICs.

8767 / 35 = £250.49 (the State Pension income you earn for each qualifying year).

The Agglomerator is due a State Pension worth £6,262 per year if he stops making NICs after 25 years of his working life. Or he could make voluntary NICs in retirement to ensure he brings home the full State Pension from age 68.

His reduced State Pension is worth 0.91% of his Total Portfolio FI capital of £686,300. His full State Pension would be worth 1.28%.

ERN’s table enables you to modify your SWR bonus depending on:

  • Asset allocation in retirement – I’ve chosen 60:40 equity:bonds.
  • Retirement length – I’ve chosen 50 years.
  • Benefit start date – I’ve chosen 22 years after FI because The Agglomerator retires at 46 but his State Pension kicks in at age 68.
  • Minimum, Median, or Maximum Value scenarios based on portfolio performance (I’ve chosen the minimum (i.e. the worst scenario) because ERN uses historic US investment returns, which may not be so bright in our future.)

Multiply ERN’s modifiers by the percentage worth of your State Pension and you have your SWR bonus. I’ve marked The Agglomerator’s bonus options in green on the table above: +0.26% SWR for his rump State Pension and +0.36% for his full one.

Either way that’s just enough to cancel the SWR drag of our investment fees. We’ll round down the rest and maybe enjoy a bit more wiggle room in the future.

If your affairs are complicated or you love modelling the detail then check out ERN’s DIY Withdrawal Rate Toolbox – a magnificent and many-headed beast of a spreadsheet. Beware those US investment returns, though.

All together now

There you have it. That’s the full, vanilla calculation, ready to be customised to fit your personal circumstances.

Once you have your plan, kick its tyres using Timeline’s free trial or Portfolio Charts or FIREcalc.

Naturally, projecting 50 or 60 years ahead involves a ludicrous number of assumptions. No plan survives contact with reality, but my aim here is to at least provide a rational platform from which you can launch yourself into the future.

I can understand the reasoning of anyone who wants to drop their SWRs by another 0.25% or 0.5%. The lower you go, the safer you may be, the longer FI will take, the more likely you are to die with pots of cash in the bank. That’s the trade-off.

Raise your SWR if you’re prepared to leave more to chance, or to  work part-time, learn some SWR kung-fu, or can fall back on a few Plan Bs – equity release, offset mortgage, downsize, rental properties, annuities, emergency fund, inheritance, a raft of defined benefit pensions, dying young 😉

The baseline SWR is most likely to be needed when market valuations are high. Now is such a time.

Next episode: I’d like to cover liability matching, more on asset allocation, GIAs and a few more case studies dealing with different circumstances.

Take it steady,

The Accumulator

  1. Disasters of unprecedented proportions notwithstanding. []
  2. The 2% employee NICs don’t quite line up with the higher rate tax band, so the spreadsheet departs from reality to the tune of about £2 in NIC payments per year. []
  3. Theoretically a ladder of inflation-linked UK government bonds would be ideal, but that’s expensive today and also technically difficult. []

Weekend reading: Vanguard is ready to let you SIPP

Weekend reading logo

What caught my eye this week.

Hard to make this sound anything like a (not paid for) plug, but I’m sure our many readers who’ve been waiting for it will all want to know that Vanguard is finally ready to take your money into its Personal Pension (SIPP).

I covered the main features of Vanguard’s SIPP back in December, so won’t repeat that again. Instead here’s a couple of other articles that have run to mark the launch.

From ThisIsMoney:

Jeremy Fawcett, head of Platforum, said the Vanguard Personal Pension’s competitiveness compared with Sipps offered by 14 other leading platforms across a range of investment scenarios, makes it ‘one of the lowest-cost options on the market, especially for those at the beginning of their journey’.

The research consultancy found that a typical investor would pay £172 per year to invest a £40,000 annual Sipp contribution, compared to an average of £238 on competitor platforms, with the most expensive charging £396.

And from the Financial Times [Search result]:

The Vanguard SIPP is initially only available to savers who are still building their pensions, or in accumulation, but is expected to open to retirees drawing on their pensions from the start of the 2020/21 tax year. This is a significant market.

There were 984,583 pension drawdown policies in existence at the end of March 2019, according to the results of a Freedom of Information request submitted by Hargreaves Lansdown to the Financial Conduct Authority.

It’s worth noting the Vanguard SIPP option may not be the cheapest in every case. Depending on how you want to construct your pension, it could not even have all the building blocks you need either, as it’s limited to Vanguard’s own funds.

Still, I think it’s probably going to Vanguard-ize the UK personal pensions industry in pretty short order. We can discuss what ‘Vanguard-ize’ means in the comments!

Have a great weekend.

[continue reading…]

Weekend reading logo

What caught my eye this week.

Last week I suggested we all remember that bear markets exist and we’ll see one again, so invest accordingly.

But we can invert this with a reminder that bull markets come and go, too.

It’s difficult to recall the pessimism of 2008 and 2009 today, after a 10-year bull run.

But it’s maybe even harder to remember how out-of-love investors were with technology companies.

One advantage of writing your own investing blog that offsets some of the disadvantages (work, trolls, looking silly in retrospect) is that it enables you to track your thinking.

Often this is embarrassing. Occasionally you get a signal that you’re doing something right.

I did vast amounts of reading when I began investing nearly 20 years ago. Real-life lessons are more valuable, though.

For instance, when I wrote about what I called the investor sentiment cycle back in 2010, I’d only seen a couple of sector-specific booms and busts – though I’d read about many more.

And it’s somewhat gratifying to extract the following snippet from that 2010 post today:

Dot come again

For a contrasting unloved sector, consider technology companies.

It’s hard to remember a time when half the office owned shares in nonsense companies like Baltimore, Webvan, and NTX.

Yet it was only a brief decade ago that the Dotcom stocks were doubling in a month on a good press release and a name change.

Today roughly nobody except institutional investors bothers with individual technology shares – yet the Nasdaq tech market in the US has been quietly beating the Dow and the S&P 500 for months.

Especially this bit further down:

Perhaps Facebook or Twitter will float for what will seem a crazy valuation, but will look positively modest a few years later.


Keen observers of the market may know that Facebook did float at $38 a share in 2012, and many pundits thought it was overpriced.

Indeed the shares plunged below $20 a few months later on fears that Facebook would not be able to capitalise on smartphone advertising.

That seems ridiculous now, particularly when you look at Facebook’s share price.

As I write its shares are up more than ten-fold from that low, at $211.

Tech tock goes the clock

Today’s investors (to some extent me included) can’t get enough of growth and tech names.

There are good theoretical reasons for this, in a low interest rate world. (See point #10 in my post on low interest rate investing issues).

But it’s surely also true that we’re happy to hold tech shares at high valuations because they’ve shot the lights out over the past ten years. Facebook is now a $600bn company, and four US tech companies in the US are valued at over a trillion dollars each!

Will this continue?

Yes –  until it doesn’t.

“Trees don’t grow to the sky”, as the old-timers used to say.

I’m not going to speculate here about when the very real potential of technological disruption is sufficiently priced-in, or whether the future will disappoint us.

But I will remind everyone again that these things move in long cycles.

Not for spooky reasons. Rather from a combination of economic reality and sentiment.

For example, emerging markets just hit a 16-year low relative to US stocks, as shown in this graphic from All Star Charts.

(Click to enlarge)

I would – and as an active investor probably should – bet that the slope won’t look that way in 2030.

For passive investors, it’s an umpteenth reminder to stay diversified across geographies, sectors (i.e. own the market) and not to get distracted by fads.

For naughty active investors, it’s a warning to stay aware. (And maybe to become a passive investor if your edge is simply that you own a lot of tech shares… 😉 )

Have a great weekend!

The title is a quote from Horace. But you knew that.

[continue reading…]


Why I’m not scared of my interest-only mortgage

An Escher painting showing houses distorting as a metaphor for seeing mortgages through different financial lenses.

Wealth warning: Interest-only mortgages are like power tools – useful in the right hands but capable of chopping them off. If you’re not sure you’ll stay interested in your finances for three decades, avoid! Get a repayment mortgage and keep life simple.

I have an interest-only mortgage. This confession causes some friends – and Monevator readers – to gasp.

Am I not a financial blogger? Don’t I know interest-only mortgages are risky? Weren’t they associated with the financial crisis?

“Are you nuts?”

I have my moments, but I’m mostly a responsible sort. And I believe interest-only mortgages are not as toxic as their off-ish odour suggests. In a couple of ways they’re arguably less risky than repayment mortgages.

Interest-only mortgages do have one big downside. We’ll get to that.

But they also have a couple of advantages.

What is an interest-only mortgage?

A quick refresher, and then on to the concerns.

  • With an interest-only mortgage, your monthly debits to your bank only pay the interest due on your loan. You don’t repay any capital – and you needn’t until the end of the mortgage term. At that point the entire debt is due.
  • This contrasts with a repayment mortgage, where you make capital repayments as well as interest payments each month. At the end of a repayment mortgage term – typically 25 years – it’s all paid off.

One obvious advantage of an interest-only mortgage is your monthly payments are lower, because you’re only paying interest, rather than capital and interest.

This may be appealing when house prices are high and interest rates are low.

Suppose you took out a £400,000 mortgage over 25 years at a ten-year fixed rate of 2.5%:

  • Monthly payments with an interest-only mortgage: £834
  • Monthly payments with a repayment mortgage: £1,795

Quite a difference! You’ve nearly £1,000 left in your pocket each month with the interest-only option.

Low rates make interest-only mortgages look like a winner. Here’s the same scenario with 1990s-style 12% interest rates:

  • Monthly payments, interest-only: £3,999
  • Monthly payments, repayment mortgage: £4,212

With very high interest rates, there’s is little difference between monthly interest-only or repayment payments. Either way most of your initial payments go on interest.

Today’s very low rate environment makes the interest-only option appear attractive when you’re only looking at monthly payments. Because rates are low, there’s little interest to be paid.1

Screamingly important: It’s not all about monthly payments!

These comparisons tell us about monthly payments – but not about the big picture of buying your home outright.

That’s because the interest-only mortgage is not being paid off.

In my example, with the interest-only mortgage there will be a £400,000 debt due at the end of the 25 years.

This gaping hole will need to be filled, either by selling your property to repay the mortgage – not usually a permitted as a plan for residential owners – or by using capital from elsewhere. (Aha!)

In contrast, the repayment mortgage will be paid off in full after 25 years. And long before then the debt will have dwindled significantly.

What’s more, the total amount you pay to own your home will be higher with an interest-only mortgage.

  • As you pay down capital with your repayment mortgage, interest is charged on a shrinking outstanding balance, which reduces the future interest due.
  • With an interest-only mortgage you pay interest on the full debt for the life of the mortgage.

I’ll get back to this in a moment.

The repayment mortgage as a piggy bank

We might think of a repayment mortgage as like a ‘forced’ savings account.

True, it’s a strange sort of savings account, because it starts with a massively negative balance – of minus £400,000 in my example – and eventually you ‘save’ back up to breakeven.

But it works the same way.

Every £1 you put into repaying off the outstanding capital increases your net worth by £1, compared to if you’d spent that £1 on sweets or beer, because you’ve now paid off £1 of debt.

If you started with a negative balance of £400,000, you now only owe minus £399,999.

You’re richer!

A repayment mortgage is often even better than a normal savings account, because you don’t pay tax on your ‘interest equivalent’ when reducing your mortgage, but you might pay tax on interest on cash savings. Depending on your total income and tax bracket2, this means repaying debt may deliver a higher return than earning interest on savings. (It’s all been made a bit more complicated by the introduction of the savings allowance though. Check out this primer from Martin Lewis if you want to do the sums.)

Of course the downside of this ‘mortgage pseudo-savings account’ is your home could be repossessed if you fail to make your payments. That’s several dozen shades darker than the worst that can happen with a real savings account.

Five perceived problems with interest-only mortgages

Let’s crack on! Let’s look at some arguments people make against interest-only mortgages, and why they aren’t necessarily a concern – and certainly don’t amount to a toxic product – in the right circumstances.

1. An interest-only mortgage is more expensive

This is one of the best arguments against using an interest-only mortgage – or perhaps I should say against misusing it.

Going back to the £400,000 mortgage charged at 2.5% for 25 years:

  • The repayment mortgage costs a total of £538,4093
  • The interest-only mortgage costs a total of £650,1134

The difference is in the interest bill. It is £111,704 higher with the interest-only mortgage. As I wrote earlier, that’s because you’re charged interest on the full £400,000 for the life of the interest-only mortgage.

Now you might be thinking you’ve spotted a gaping hole here in the logic of using an interest-only mortgage.

We’re trying to get richer around, right? Not poorer.

But as mathematician Carl Jacobi’s maxim states5 “Invert, always invert.”

With the interest-only mortgage in this example, you are effectively paying £111,704 in additional interest6 to rent £400,000 from the bank for 25 years.

After that, money that would have gone into repaying the mortgage can instead go into investments that will probably deliver a higher return overall.

Not a higher return than house price growth – that’s irrelevant here, see point #3 below – but a higher return than the 2.5% interest rate your bank is charging, adjusted for your personal tax situation.

That basically means global equities – shielded from taxes in an ISA or SIPP – which might be expected to deliver annual returns of around 7-8% a year, depending on who you ask and what period they look at. (Remember we can use nominal returns here, because your mortgage interest rate hurdle is also nominal. In real terms the value of your £400,000 debt is being shrunk over time, too.)

If you use an interest-only mortgage and invest, you’re effectively gearing up your portfolio with the mortgage debt. Every pound of debt that’s not repaid is effectively invested into your portfolio instead, for 1-25 years.

If all goes well, you’ll end up richer. After 25 years you’ll pay off your mortgage balance and the excess (we hope) is yours to keep.

Of course it’s not a slam dunk. Investing in equities – even with a lengthy 25-year time horizon – is much riskier than repaying a mortgage, which delivers a known return. There are no guarantees.

Also tax looms large. Compare an after-tax gain on equities with an effectively juiced-up after-tax return from paying down debt, and the potential differential shrinks.

For me this means that while I have headroom in my annual ISA and SIPP allowances, I’m planning to effectively run a larger, leveraged, tax-sheltered investment portfolio, rather than pay down my interest-only mortgage – at least for the next 10-15 years.

If I have spare cash after that (after an emergency fund and so on) I’ll throw it at the mortgage.

This is definitely a personal decision, and I guarantee people will turn up in the comments saying it’s too risky and you should just pay down your mortgage debt.

Notice though that these same people will often be paying into a pension while carrying a repayment mortgage – in some ways a similar proposition, though not one I’d personally argue against for a minute – or perhaps they had a defined benefit pension and were never faced with such decisions. (Certainly anyone who says using an interest-only mortgage while they themselves have a repayment mortgage at the same time as they’re saving into an ISA, let alone a general un-sheltered investment account, is riffing on their cognitive dissonance!)

Remember too that plenty of people have taken out interest-only mortgages without any plans to repay the debt. This is mostly why interest-only mortgages have a stinky reputation. But that is the opposite of what I’m suggesting here! I’m doing this entirely to grow my wealth, a portion of which should one day be used to pay off my outstanding mortgage.

Also note that you have some optionality with the interest-only approach.

My interest-only mortgage T&Cs allow me to repay up to 20% of the outstanding debt off in any particular year.

If markets do much better than I expect at any point over the 25-year term, then I can switch from investing more to repaying the interest-only mortgage before the debt becomes due, or maybe even deploy lump sums liquidated from my ISAs against the mortgage (though it’s hard for me to conceive of doing that and losing some of my precious ISA wrapper…)

Ditto if interest rates rise, and it becomes more expensive to run the interest-only mortgage.

Here’s a couple more articles to read on the topic:

As so often, it’s make your own mind up stuff.

The Accumulator changed his mind in a similar-ish situation and decided to focus on reducing his mortgage debt rather than maximising his investing gains. No shame in that!

2. You’re not reducing the capital you’ll eventually owe

The second – also excellent – argument is that paying off, say, £400,000 is a massive slog for most of us, and you’d be best off starting early.

I agree that for many people this is wise advice.

However even with a repayment mortgage you might not be repaying much capital in the early years, depending on rates.

Sticking with my £400,000/2.5% example (and rounding for ease of reading) in the first year of a repayment mortgage you’d pay £9,860 in interest. You’d only pay off £11,666 of the outstanding capital.

So that’s roughly 45/55 interest to repayment.

The figures do get better over time. By year ten you’re repaying £14,610 a year in capital, with less than £7,000 going on interest. This is because your prior repayments have shrunk the debt that interest is due on.

But a big chunk of your early bills are actually going towards servicing interest, even with a repayment mortgage.

And it’s much worse when rates are ‘normal’.

At a more historically typical mortgage rate of 6%, you’d pay nearly £24,000 in interest in year one on that £400,000 loan, and merely £7,000 of the capital.

That doesn’t seem so much a repayment mortgages as a mostly-interest-mortgage!

Here’s an illustration of the interest/capital split under a 6% regime. Notice how long it takes for capital repayments to outweigh interest payments:

With a 6% interest rate, even a repayment mortgage is mostly paying interest early on.

Of course we don’t currently live in a 6% regime. You could argue that with today’s low rates it’s actually a great time to have a repayment mortgage and to slash your long-term debt, exactly because most of your payments are going on capital.

It’s a coherent argument.

My point is simply that both interest-only and repayment mortgages feature a lot of interest-paying, at least initially.

It’s just a bit disguised, because when a bank rents you money to buy a house, it all gets wrapped up in one monthly bill.

3. You’re not smoothing out your housing exposure

This argument is wrong thinking, but I’ve heard enough people say it that I suspect it’s pretty common.

The (faulty) logic goes:

With a repayment mortgage, you’re gradually increasing your exposure to property as you pay down your debt.

Often they will add something like:

“The stock market looks wobbly, so instead of investing I’m going to make some extra payments towards my mortgage in order to put more into the property market instead. You can’t go wrong with houses!”

I’ve even had a friend suggest to me that repaying his mortgage over time (including with over-payments) is like pound-cost averaging into the stock market.

But while this certainly results in good financial discipline, the theory itself is nonsense.

When you buy a property is when you get your ‘exposure’ to the housing market. Your exposure going forward is the property you bought. The cost of that asset is the price you paid when you bought it.

Everything else is financing.

Most of us take out a mortgage to buy our home. How we choose to pay that off – every month for the life of the mortgage or in one lump sum in 25 years, or something in-between – is about managing debt, not altering our property exposure.

If you make an extra £50,000 repayment towards your mortgage, you haven’t got £50,000 more exposure to the housing market. Your property exposure is still whatever your house is worth.

Rather, you’ve paid off some debt (/done some enforced saving!)

True, it’s debt that is bucketed against the specific asset of your home. But that’s it.

The way to pound-cost average into the residential property market is to buy multiple properties over time, or to invest in a loft extension or similar.7

4. What if you can’t make the interest payments – you won’t own your home?

People seem to believe using an interest-only mortgage is more precarious than a repayment mortgage. You often see this insinuated in articles.

There is a feeling that somebody living in a home financed with a mortgage where they’re not paying down debt each month is living on a limb.

But your financial situation is more than just your house and your debt.

It includes your cash savings, your investments, your pension, your monthly income, your liabilities, and more.

When I bought my flat with an interest-only mortgage, I put down a 25% deposit. Since then I’ve repaid almost no capital8.

In contrast, my friend P. bought a flat around the same time as me with a 20% deposit and a repayment mortgage. He will have since repaid a couple of percent of his mortgage.

I don’t see that he’s in a more secure position than me, on these bald facts alone.

  • Neither of us own our properties outright.
  • Both of us could be repossessed if we fail to make our mortgage payments.
  • He’s made bigger monthly payments to his bank. I’ve put a higher percentage of my net income into investments.

You could even argue that my interest-only mortgage is less risky, on a month-to-month basis. My monthly payments are lower, and so they would be easier to meet in a pinch. The rest of the time I can – and am – diverting the spare cash into building up my other savings and investments, not spending it.

This actually gives me more of an accessible ‘liquid’ buffer than he has.

With an interest-only mortgage you can also spread your assets more widely than someone who is putting everything into paying down their repayment mortgage ASAP.

Their assets may be very over-weighted towards one single residential property. More of yours will be in global shares and bonds (effectively financed by your mortgage…) in addition to property .

Of course, if you just use your lower interest-only payments to live beyond your means rather than building up your investments then it’s a different story. I’m not arguing for paying lower monthly bills and then moaning to the regulator in 25 years that you didn’t understand you had a debt to repay!

But blame the player in that case, not the game.

5. You don’t ‘really’ own your home, even if you do keep up the payments

My mum said this to me. She seems to believe she always owned her home because she was paying off her mortgage each month, whereas because I’m not she thinks I don’t own mine.

This is all hand-waving stuff.

Some people say the same about homes bought with repayment mortgages, too. They say the bank ‘really’ owns your house. That you’re just renting until you’ve paid off the mortgage. Until then you’re a tenant of the bank, which is the ‘true’ owner.

This is wrong, legally speaking.

When you buy a house you take legal ownership of that property9. It’s registered under your name at the Land Registry, and you have various rights and responsibilities that come with ownership.

If you happen to buy it with a mortgage, then you’ve also taken on commitments to the bank that lent you the money.

Because some people don’t repay their debts, banks want some security.

And… you’ve just bought a home… so hey, there’s a big lump of hard-to-move security sitting right there!

Invariably then, when a bank lends you money to buy a property, this loan is secured against that same property. That’s why the bank gets your property valued beforehand. (You didn’t think it was for your benefit, did you?)

There are all kinds of implications from using a mortgage like this, but not owning your home isn’t one of them.

Of course with an interest-only mortgage you do need to repay the debt eventually to stay in your home. Your 25 years of home ownership will come to an end if you have to sell your home to pay off your mortgage.

That’s 100% true.

But it’s not a reason to avoid an interest-only mortgage – it’s a reason to have a plan.

Outstaying your interest

There’s a vogue on this site at the moment to crunch numbers, but at 3,000 words I think this article is weighty enough.

Boiling it down, it’s a pretty simple concept…

Investment returns > extra interest-only mortgage costs = win

Investment returns < extra interest-only mortgage costs = loss

… maybe adjusting your investment returns by a risk factor to reflect the uncertainty of gaining them.

I’ll say it again, to try one last time to stop someone in the comments saying I said something else – for most people, a repayment mortgage is a simple, reliable way to buy a home. It will probably reduce your financial vulnerability over time. It should be the default choice.

But for those of us who like to juggle our finances for fun and profit, an interest-only mortgage is well worth considering.

  1. Then again, high rates usually come with high inflation, and that would be eroding the real value of your debt quicker. []
  2. And the interaction with your personal savings allowance. []
  3. Mortgage debt of £400,000 and interest of £138,409 []
  4. Mortgage debt of £400,000 and interest £250,113 []
  5. via Charlie Munger. []
  6. Of £250,113 in total interest. []
  7. Or to buy shares in one of the few listed companies that owns substantial amounts of residential property, such as Mountview Estates. []
  8. I made one small ad hoc payment to ensure it worked. []
  9. Well, assuming you own the freehold. It’s more complicated with a leasehold property, but let’s save that for another day. []