If you have some spare cash left over at the end of the month, are you better off overpaying your mortgage, putting money into savings or topping up your pension pot?
Mortgage rates have risen for 80% of households over the last two years, with around 1.5 million homeowners set to be hit by rate rises in 2024. These increases have had a notable impact on the housing market. Despite the recent Bank of England interest rate cut, average two-year fixed mortgage rates sit at 5.76%, according to Moneyfacts, up from the 2.34% average rate in 2021.
If you have a mortgage deal that dates back to before rates shot up, here's what the experts say you need to think about.
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Should you overpay your mortgage?
Before deciding to overpay your mortgage, there are several considerations you need to make, says Jo Jingree, MD of mortgage advice firm Mortgage Confidence.
Chief among them, she says, is whether you have sufficient savings to weather a financial emergency. She adds: "Overpaying your mortgage is a fantastic idea but only if you have a good level of savings first and foremost.
"Also consider if your lender will charge you an early repayment charge for the overpayment – most lenders allow overpayments of up to 10, or even 20% of your balance per annum but not all, so always check before you overpay."
What to do before overpaying your mortgage
1. Pay off high-interest debts
Anyone thinking about overpaying on their mortgage should first pay down expensive debt, such as credit card bills or overdrafts, says Laura Suter, head of personal finance at AJ Bell.
If you have savings and also interest-bearing debts, it will almost always make sense to use the savings to pay off the debts.
Example:
Some who has £1,000 in an account earning 4% interest, but owes £1,000 on a credit card at 19.9%. Over a year you would earn £40.74 interest on your savings, but you would have to pay £93 in interest on your credit card, even if you paid off £100 a month.
So the most profitable option is to use your savings to clear the debt and avoid paying interest.
2. Create a rainy day fund
Once you've paid off any expensive debts, you should "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.”
Once you've paid money into your mortgage, you can’t get it back, so ensure you have enough in your emergency savings fund first. It’s wise to keep money in an easy-access account so you can get it when you need it, for events such as a broken boiler.
3. Check your mortgage provider allows overpayments
If you have a fixed-rate or a discounted-rate mortgage it is likely to have early repayment charges which could be triggered by overpayments. Those charges would easily wipe out any interest savings. So, it's important to check what your lender’s rules are on overpayments before you start making them. Many lenders will allow you to overpay as much as 10% of your outstanding mortgage debt each year. If you are on a variable-rate mortgage you may be able to overpay more. You can usually make overpayments by increasing your monthly direct debit or by making one-off transfers.
Benefits of overpaying your mortgage
“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.”
Nicholas Mendes, mortgage technical manager at John Charcol, agrees: "By making extra payments towards your mortgage principal, you can reduce the outstanding balance faster and pay less interest in the long run."
Example:
Someone who borrowed £200,000 over 25 years, with an interest rate of 4.5%, would have mortgage repayments of £1,111 a month.
- Overpaying by £200 a month would save you around £36,281 in interest and see you pay your mortgage off six years earlier than planned.
- Overpaying by £100 a month would save you around £21,142 in interest and see you pay your mortgage off three years and six months earlier than planned.
Mendes adds: "As you make mortgage overpayments, you're effectively building equity in your home at an accelerated rate. Increased equity provides you with more financial stability, whether you decide to move home or release equity for home improvements.
"By reducing your outstanding mortgage balance, you'll be better prepared to handle market fluctuations. When interest rates rise, having a lower outstanding balance can cushion the impact on your monthly mortgage payments."
Mortgage overpayments or higher pension contributions
There are many reasons why putting extra money into your pension might make more sense than making mortgage overpayments.
“Money that's put into a pension benefits from tax relief. It 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.
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 the Mortgage Advice Bureau (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.”
A 2023 study by interactive investor runs through a number of scenarios, crunching the numbers on the question of prioritising mortgage overpayments or pension contributions.
The table below details an example of someone with a £200,000 mortgage, over a 25-year term, with a spare £200 each month and on the basis interest rates remain static. Here’s how the money would change their potential outcomes depending on whether they focused on mortgage overpayments first, or went straight to pension contributions.
| 6% interest rates, 5% investment growth | 6% interest rates, 6% investment growth | 5% interest rates, 6% investment growth | ||
|---|---|---|---|---|
| Option 1 | Overpaying mortgage first and then pension (with tax relief) | £165,901 | £171,455 | £152,758 |
| Option 2 | Paying into pension first | £148,877 | £173,248 | £173,248 |
| Option 3 | Overpaying mortgage first and then pension (no tax relief) | £132,720 | £137,164 | £122,224 |
| Difference between options 1 & 2 | £17,024 | £-1,793 | £-20,490 |
Assumptions: 25-year repayment mortgage, 20% tax relief
Option 1,2 & 3 - overpayment into mortgage or pension of £200 per month
Option 1 & 3 - once the mortgage is paid off, divert mortgage payment into a pension, returns net of investment fees
As Alice Guy, personal finance editor at interactive investor, notes, the reality is that interest rates do not remain static, so at different points it may make more financial sense to focus on either savings, mortgage overpayments or pension contributions.
The role of tax relief on pension contributions is also a crucial consideration. Guy says: “If you’re a higher rate taxpayer, it’s also possible that you won’t get as much tax relief if you decide to wait to boost your pension wealth. It’s possible that you’ll not earn enough in the future to get a higher rate of tax relief if you pile a large amount into your pension in just a few years.”
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, 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 in a savings account that you can access easily may make more sense.
Factors as varied as your age, mortgage term, mortgage product and available savings rates will have a bearing on the calculations. As ever, it's worth taking expert advice before making these decisions.
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