Overpaying your mortgage - is it a good use of cash?

Mortgage rates have climbed consistently over the last six months, following a series of interest rate rises by the Bank of England (BoE). 

At the end of 2021, borrowers had access to mortgages with rates of 2%. Now the average two-year fixed rate is 5.44% and five-year fixes have an average rate of 5.2%, according to Moneyfacts. 

This means those homeowners are potentially facing much higher borrowing costs (although there are increasing signs the mortgage market is becoming more competitive). 

As a result, new borrowers are retreating from the market as they wait for better rates. 

Mortgage borrowing fell by £1bn between November and December, according to the BoE. This is also having a huge impact on house prices and activity in the housing market across the country. 

Given the high-interest rate environment, current mortgage holders with any excess money might be wondering whether they should prioritise overpaying their mortgage. 

But is this a good use of cash or could you get a better return in the long run with other assets? 

Should you overpay your mortgage?

“After a long period of ultra-low interest rates, many of us are facing a dilemma in 2023,” says Alice Guy, personal finance editor at interactive investor. 

“Interest rates are on the rise and thousands of us on fixed mortgage deals are frantically overpaying our mortgages before they’re due for renewal at a higher interest rate.” 

“But we also know that, in the long run, many of us need to boost our pension contributions to help us achieve a big enough pot for a comfortable retirement,” Guy says. “Leave those pension payments to the last minute and we’ve less time for investment compounding to boost our wealth.”

Ultimately, deciding whether or not to overpay your mortgage comes down to your personal financial situation. 

When should you start overpaying your mortgage? 

Anyone thinking about overpaying on their mortgage should first pay down expensive debt, such as credit card bills, overdrafts or store cards, says Laura Suter, head of personal finance at AJ Bell. 

“Once that’s done you need to build up a cash buffer to cover between three and six months of expenses to fall back on if you hit an expected financial bump in the road.” With interest rates rising, there are a growing number of highly competitive savings accounts on the market. 

After that, you need to check that your mortgage provider allows repayments. Some might limit overpayments to a percentage of what you owe, while others might charge early repayment fees. 

You also have to decide how much you can afford to overpay, and whether you want to overpay monthly or as a one-off. 

“Overpaying each month, even if it is as little as £100, will likely save you money in the long run,” says Brian Murphy, head of lending at Mortgage Advice Bureau. “It also offers you more flexibility if you come into a situation where you need that extra cash - you can simply lower your payment to the pre-agreed fee.” 

“Paying in one large lump sum will likely help you clear the mortgage faster and will certainly reduce the interest you are paying. However, if you suddenly need that extra money back, you won’t be able to withdraw it from the mortgage, so only do this if you know you won’t need that money.”

“To release that equity again you would need to re-mortgage or take out a second mortgage, which can be much more expensive,” says Suter. 

Still, with the cost of borrowing rising, paying down any outstanding debt does make a lot of sense, even if you’re on a fixed-term deal. 

“The lower your balance, the less this rise in interest will affect you,” says Becky O’Connor, director of public affairs at PensionBee. “So actually, by increasing your mortgage payments, you would also be preserving your ability to increase your pension contributions in future, too, by reducing the overall burden of mortgage interest on your finances, all other things being equal.”

The benefits of overpaying your mortgage

Paying your mortgage off faster than planned will reduce the amount of interest. With an interest rate of 3%, someone who borrowed £200,000 over 25 years would pay £948 a month. Overpaying by £200 a month would save you around £21,620 in interest and see you pay your mortgage off six years earlier than planned. 

Someone with the same mortgage on a 6% interest rate could make a saving of £32,017 by overpaying £100 a month. You can use our sister site The Money Edit’s mortgage overpayment calculator to work out how much you could save based on your individual circumstances. 

It’s also worth thinking about options that will open up later on – such as downsizing. Trading a larger home for a smaller one could leave you with extra cash you can use towards paying off the remainder of your mortgage. 

Should you prioritise pension contributions? 

If you decide to overpay, it’s important not to compromise your pension contributions. Indeed, there are many reasons why putting extra money into your pension might make more sense. 

“Money put into a pension benefits from tax relief and also benefits from often being invested in the stock market for a long period of time, enjoying the magic of compound interest and the possibility of riding out any volatility in the markets,” says Karen Noye, mortgage expert at Quilter. 

The early years of saving for retirement are important due to the effect of compound interest, or the interest you earn on interest. By prioritising mortgage contributions earlier on in life, you could be giving up valuable investment growth. 

“Most pensions will grow between 2% and 3% a year which might not seem like much, but over a long period and with a larger amount in the pot, this does add up,” says Murphy from MAB. 

Additionally, even though mortgage rates will remain elevated in the short-term it's likely they will come back down. So, it might not make sense to put all of your extra cash towards your mortgage.  

“Investing in the stock market has historically given the greater return particularly when invested via a tax-efficient product like a pension,” says Noye. 

“Therefore together the power of tax relief and fund growth over a long-term horizon may make it better to allocate additional funds to your pension especially if you are paying more than just the basic rate tax.”

The verdict

As with all financial matters, there is no straightforward answer. What you do will depend on your priorities, circumstances and appetite for risk. 

If you think ultra-low mortgage rates might make a comeback in the near term, then putting the money towards your pension and letting interest compound might be more appealing than paying your mortgage off quickly. 

If you think you might need this extra cash for any reason in the near term, then keeping it somewhere you can access it easily will make more sense. 

If you want to prioritise paying your mortgage off early so that you know it’s one bill you don’t have to worry about later on, or just because you want to tick it off your list of goals, then that might seem like the obvious choice. 

Things such as your mortgage term, interest rate, age and job status will also factor into the equation. “It is therefore key to weigh this all up and it is best to speak to a professional financial adviser who can help you navigate these variables and get the best possible outcome for your unique financial situation,” says Noye.