You might be surprised to hear that it’s not necessarily always the best decision to overpay your mortgage. In this article, our expert team of mortgage advisers at PIL Southampton explains why.
A key benefit of overpaying your mortgage is the saving you could potentially make by reducing your mortgage balance sooner, therefore paying less interest over the long term.
For example, if you are paying 5% interest on a £250,000 mortgage, you have 25 years of your mortgage term left, and you overpay by £5,000, you will be reducing your interest by £11,970 and shortening your mortgage term by 11 months.
This example is based on a repayment mortgage with a constant interest rate over the remaining term.
Another benefit of overpaying is that, if you overpay when interest rates are relatively low, your mortgage balance will be smaller if and when mortgage interest rates increase in the future – meaning that you will be less impacted.
One downside to be aware of is the early repayment charge (ERC) that your mortgage deal might include if you overpay more than they allow – the ERC is usually 1-5% of the amount you overpay. Read on for more about this.
Another potential negative to consider before you overpay is that, once you do, that money is gone. If you’re leaving yourself with little or no cash buffer by overpaying, then you could find yourself financially vulnerable if you have unexpected costs in the future, or if you’re unable to work due to illness or because you lose your job, for example.
In some cases, you could save tens of thousands of pounds over your whole mortgage term.
Even relatively small overpayments could significantly reduce the interest you need to pay and shorten the length of your mortgage term, being financially advantageous than saving the same amount of money.
Here are some examples, courtesy of MoneySavingExpert:
SAVING/ OVERPAYMENT EACH MONTH | MORTGAGE TERM REDUCTION | TOTAL INTEREST SAVED OVERPAYING A £150K MORTGAGE AT 4.5% (1) | INTEREST IF YOU SAVED THE OVERPAYMENT AT 4% (2) |
£10 | Six months | £2,470 | £2,006 |
£50 | Two years, six months | £11,180 | £8,282 |
£100 | Four years, six months | £20,010 | £13,357 |
£200 | Seven years, seven months | £33,130 | £18,463 |
£500 | 12 years, 10 months | £54,890 | £21,014 |
£1,000 | 16 years, 10 months | £70,570 | £17,703 |
First, compare your mortgage rate with the rate you could get from your savings – if your mortgage is roughly the same, or higher, than your savings rate then it could make sense to overpay.
Looking at it this way round is important because, if you focus on the savings rate, then it being higher than your mortgage rate won’t necessarily mean that it will always be a better financial option than overpaying your mortgage. This is because it will depend on various factors like whether you’re planning to make regular overpayments over a long period, or whether you’re going to make a one-off lump sum overpayment.
Other relevant factors will be how big your mortgage is, how long you’ve got left on your mortgage term, and whether you pay tax on your savings.
Don’t overpay on your mortgage if you have expensive debts like high interest rate credit cards and unsecured loans – clear those first. Note: This rule doesn’t apply to official loans from the Student Loans Company and to 0% credit cards.
It’s worth considering if paying more into your pension to further build your retirement pot and benefit from employer contributions and the government’s tax relief could be more beneficial to you financially than the money you would save in mortgage interest by overpaying.
Check the terms and conditions of your mortgage regarding how much you can overpay without paying a penalty. Most Standard Variable Rate (SVR) and some tracker mortgages let you overpay as much as you like, and most fixed rate or discount mortgage deals let you overpay up to 10% of your mortgage every year.
If you go over your lender’s overpay limit, you could typically be charged a fee of 1-5% of the amount you overpay.
Before you overpay, it’s worth making sure you have an emergency fund of cash, ideally three to six months of money that you could live off if you couldn’t work, for example.
Overpaying your mortgage doesn’t mean that you won’t be charged for missing a future mortgage payment if you can’t pay due to needing emergency cash for something like a replacement boiler. An exception to this would be if you have a flexible or offset mortgage; they allow you to overpay then draw back the money if you need it in the future, without being charged.
As well as the advantage of overpaying a mortgage meaning that you’re paying less interest as it’s applying to a lower amount of mortgage capital debt, overpaying also means that you are improving your ‘loan to value’ (LTV). This could give you access to more attractive interest rates when you remortgage at the end of a fixed rate period.
Before you make your overpayment, consider the timing. If your mortgage interest is charged daily, then the sooner you make your overpayment the better. However, if your mortgage is calculated annually, make sure you time your overpayment so that it’s counted towards the calculation of the interest for the year.
Overpaying your mortgage via online banking, or through your mobile banking app, is probably the simplest route. If your mortgage is held with the same bank or building society that you bank with, then you should be able to transfer between the two accounts.
If not, you will probably need to set up your mortgage account as a new payee to transfer the overpayment to.
When you choose to overpay, your lender is likely to give you the opportunity to either:
1) reduce the next month’s/months’ payment/s by the amount you’ve overpaid, or
2) to keep your payments the same and reduce the overall mortgage balance.
Which you choose is important – keeping your payments the same and reducing the overall balance means that you’ll be shortening your overall mortgage term and reducing your overall interest payments.
However, if you just reduce upcoming payments, you’re only paying a little early and only saving a relatively small amount of interest.
Overpaying your mortgage can have a similar effect to officially reducing your mortgage term. Just like officially reducing your mortgage term, overpaying your mortgage means that you’re paying more off your capital debt, you’re paying less interest in total, and you’ll be clearing your mortgage earlier.
However, if you officially reduce your mortgage term, it will increase your monthly payments every month, which might not always be convenient, and you could also need to go through new affordability checks.
Overpaying is more flexible in that your regular monthly payments stay lower, and you can choose when it’s a good time for you to overpay, as long as you are within the limits of your mortgage.
Our expert team of financial advisers is here to guide you through your options, taking the time to understand your overall financial circumstances so that they can help you to make the best decisions for you.
You can email us, fill out the contact form on our website or call us on 02380 668407. We look forward to hearing from you.
This article is for general information only and does not constitute financial advice.