Should you overpay your mortgage?
People are keen to cut the size of their home loans, but is overpaying your mortgage the best option?
Homeowners are racing to get rid of their mortgages. With easy-access savings rates running at just 0.6%-0.7%, households are instead using their lockdown savings pile to overpay the mortgage. “An average of £1.81bn of mortgage debt was overpaid each month from January to August”, says Imogen Tew in The Sunday Times. That is up by a quarter on last year and puts 2021 on course to be a record year for overpayment. Santander says a third of its customers have “made a lump sum overpayment on their loan this year”.
Overpaying clears the mortgage debt more quickly and reduces the amount of interest you are charged. That can add up to big savings. Take a borrower with a £200,000, 25-year mortgage at a 2.5% interest rate, says Stephen Maunder in Which. A £50 a month overpayment would see the mortgage cleared 22 months early, saving the borrower £5,368 over the term of the mortgage. Overpay £200 a month and the mortgage would be cleared nearly six years early, with an interest saving of £17,358. Not all households will be able to sustain such regular outgoings, but more “ad-hoc overpayments” made as and when you have cash to spare can also make a difference.
Most fixed and tracker deals set limits on how much you can overpay, typically about 10% of the remaining balance, says Dan Base for money.co.uk. It’s important not to exceed those limits, lest you be hit with early-repayment charges. Get in touch with your lender before overpaying to check what their rules are. Also consider when the interest on your loan is calculated (this can be daily, monthly, quarterly or annually depending on the mortgage). “Money put towards your mortgage is only counted after interest is calculated” so time payments to make sure they are actually reducing your interest bill.
Is it worth overpaying your mortgage?
Don’t make mortgage overpayments at the expense of an emergency fund. The general rule is to have readily accessible cash equivalent to three to six months of living expenses to finance emergencies such as a broken boiler, or in case you lose your job. You don’t want to be forced to borrow new funds if disaster strikes.
Using extra income to clear high-interest debts such as credit cards is also a higher priority than paying down much cheaper mortgage debt. Once that is taken care of, the next question is whether there are any better uses for extra cash. Topping up a pension is one option, as these have historically produced higher long-term returns than overpaying a mortgage is likely to – and investing via a pension means you can profit from tax relief and, if it is an occupational pension, a monthly employers’ contribution that matches yours.
That implies locking money up for years, however, and there is no guarantee that markets will continue to produce healthy returns. If you find yourself with large cash balances you can’t or don’t want to invest, then offset mortgages may be worth a look when you next remortgage. These flexible mortgages allow you to use cash savings to reduce how much interest you pay on the loan. If you have a £250,000 loan and £20,000 in the linked bank account you will only be charged interest on £230,000. They don’t offer the most competitive interest rates, but offset mortgages do combine some of the benefits of mortgage overpayment with the ready liquidity of a savings account.