Should you overpay your mortgage or invest?

As interest rates rise, homeowners with spare cash may be wondering if they should overpay their mortgage. Or is investing a better option? We explain which one might be best for you.

Millions of households have seen a big jump in their mortgage rate or are bracing for a sharp increase this year, as a result of rising interest rates.

Bank of England rate is currently 3.5% and is expected to hit 4.5% in the coming months. Many borrowers coming to the end of a fixed-rate deal will now be remortgaging onto deals around 5%, after enjoying years of paying interest of less than 2%.

Those with spare cash may be wondering if it’s best to overpay their mortgage to reduce the debt quicker. Meanwhile, others may be considering investing the money and hoping they can get a better return.

We look at how the two options compare, and which one might be right for you.

The benefits of overpaying your mortgage

Overpaying your mortgage means you can reduce the amount of interest you pay and clear your debt faster.

For example, someone who borrowed £250,000 over the course of a 25-year mortgage would pay £1,186 a month, assuming an interest rate of 3%.

If you overpaid by £200 a month, you’d save £22,812 in interest and reduce your mortgage term by five years.

For someone with the same £250,000 mortgage, but a 6% interest rate, overpaying by £200 a month means you'd save £57,639 in interest and reduce your mortgage term by six years.

So, overpaying when your mortgage rate is higher can have a bigger impact; you can dramatically reduce the amount of interest and become mortgage-free quicker.

Have a look at our sister site The Money Edit’s mortgage overpayment calculator to see how much you could save based on your own situation.

Rob Morgan, chief investment analyst at the wealth manager Charles Stanley, comments: “One thing is for sure, you’ll save thousands of pounds in interest by paying your debt down sooner. The longer you have the mortgage and the higher the interest rate, the more you pay in interest. This is especially true in the early years when the loan balance is larger, and you are proportionally paying a lot more on the interest than the capital.”

What to consider before you overpay your mortgage

Overpaying your mortgage is generally considered to be savvy financial planning. However, there are a few things to consider first.

Evangelos Assimakos, investment director at Rathbone Investment Management, points out that households should check they have a decent cash buffer first, of at least three to six months worth of outgoings. This should be held in an easy-access savings account, which can be used for any unexpected financial expenses, such as the boiler breaking down, or your energy bill suddenly rising. 

“If consumers have excess cash over and above three to six months expenditure, they should tackle their highest interest debt first (credit cards, loans, and overdrafts). If they have no such debt and only have a mortgage, only then should they consider paying it down,” advises Assimakos.

Credit cards and loans are often more expensive than mortgages, so try and pay those off first.

If overpaying your mortgage seems like the best use of your surplus savings, there are two more things to check. First, find out if there are any overpayment penalties. Most lenders allow borrowers to overpay up to 10% of their remaining debt each year. If you exceed this, you could be hit with hefty penalties.

Second, make sure you’re actually reducing your mortgage term, rather than reducing your future repayments. This will ensure you pay off your mortgage faster and pay less interest. 

What about investing the money instead?

According to Morgan, overpaying your mortgage comes with an “opportunity cost”. He explains: “In other words, had you invested the money, could you have achieved a return in excess of the interest on the debt? Building wealth over decades by allocating capital to well managed and growing companies has, historically at least, been a reliable way to grow wealth. However, to fully harness the power of the stock market and enjoy the benefit of compounded returns, you need to leave your money invested for a long time.”

So if you invested instead, and your portfolio returned 5%, this will have been a smarter move than overpaying a mortgage with a lower rate of say 3%. 

However, mortgage rates are currently high - the average two-year fixed-rate mortgage is 5.79% - and so there is arguably less of an opportunity cost. “It is one thing bettering a 2% or 3% rate with investment returns, but achieving upwards of 6% consistently is much more difficult. The higher interest rates are, the more it makes sense to repay debt as quickly as possible,” says Morgan.

As well as comparing the numbers, it’s important to think about how much risk you’re willing to take.

Assimakos notes: “The key consideration is that investing is a longer-term endeavour, and you need to be comfortable leaving your money invested for at least three to five years, as well as accepting that markets can be very unpredictable, and you can lose money.”

On the flipside, compounding returns and investing as much extra money as possible over  a long time-frame can be a hugely powerful force – provided your investment strategy is sound.

Is investing a good idea right now?

After a turbulent year last year, you may be wondering whether it’s safe to put your money in the markets.

Alice Haine, personal finance analyst at Bestinvest, the investment platform and coaching service, says declines in both equities and bonds in 2022 were due to “traders reacting to this new era of runaway inflation, rising interest rates, higher borrowing costs and the ongoing war between Russia and Ukraine.  

“As a result, global equities fell 5.7% over the 12 months and global bonds dipped 5%, including income received.”

However, investing should always be for the long term, and some investors will of course have done well last year, especially if they managed to snap up some bargains. On a more positive note, the FTSE 100 performed strongly last year, returning a healthy 8%.

Haine tells MoneyWeek: “The markets might seem volatile right now, but time in the markets, rather than timing the markets, is always the secret to riding out the declines.”

How can I decide which is better for me? 

Ultimately, the decision to overpay a mortgage or put money into investments depends on your circumstances, stage of life and your time horizon. 

For example, someone about to retire with a mortgage still in place should arguably focus on paying off their home loan first to free up income for other living expenses. Meanwhile, someone in their 20s might want to invest their spare cash to take advantage of time in the markets. 

Haine highlights another scenario: “If household cash-flow is tight, those with spare cash and a mortgage expiring soon can direct their money towards overpayments rather than topping up investments. This will become even more important as property prices decline, as overpaying protects the loan-to-value ratio, which can determine access to more favourable mortgage rates.”

Experts agree that depending on the amount of spare cash available, an ideal solution could be to overpay your mortgage and invest. The former means you can get ahead of higher repayments if you’re going to be remortgaging soon, and make you more financially resilient as you pay down debt. 

And investing can help beat inflation and grow your wealth.

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