Switching to a better mortgage deal or paying off a mortgage earlier can be a sensible financial decision. However, most lenders will demand early repayment charges if you try to change your loan before the deal term ends.
But with interest rates set to hit 5.75% next year according to City analysts, switching today and swallowing the extra repayment charge could save you thousands of pounds on your mortgage repayments.
What are early repayment charges?
An early repayment charge is a fee you might have to pay your lender if you decided to end your mortgage deal before the “official” deal term ends.
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For example, let's say you have a five-year fixed deal that ends in March next year. By March, mortgage interest rates might have jumped significantly, so you choose to refinance now and lock in the lower rate. But most lenders will charge a fee for doing so, usually expressed as a percentage of the overall borrowing figure.
Early repayment charges also usually apply if you pay off more than a set amount every month. A provider might let you pay off up to 10% of the outstanding balance each year; any more and a fee might apply.
Mortgage providers have early repayment charges to discourage borrowers from switching, although they tend not to apply to standard variable rate (SVR) mortgages. These products might come with an admin fee if you want to leave, but the cost will only be a few hundred pounds.
The cost of repaying your mortgage early
Early repayment charges are not usually a flat rate fee, which means it can be difficult to decide if it’s really worth switching before the end of the deal.
These charges are usually calculated as a percentage of the balance outstanding. The typical cost is between 1% and 5%, although the cost can vary depending on how far you are into your deal.
For example, if you have £300,000 outstanding on your mortgage, and the lender’s early repayment charge is 3%, it would cost £9,000 to settle the loan in full. This means early repayment charges fall the closer you get to the end of your loan.
And while a large lump sum like £9,000 might seem like a daunting amount to pay upfront, repaying early could save you a fortune in interest charges.
Doing the sums on early repayment charges
Let’s say you have a £350,000 mortgage with a year left on a two-year fix at 1.2%. If the early repayment charge is 2%, you would pay around £7,000 to exit the deal early.
If you then remortgaged onto the current best five-year fix, you could get a new rate of 3.99% from Reliance Bank (assuming a 75% loan-to-value ratio). That would take your monthly repayments from your current £1,352 up to £1,845, assuming you have a 25-year mortgage term.
Over the next 12 months, your new mortgage will cost you £5,916 more than if you had stuck with your two-year fix – plus the £7,000 early repayment charge. That is a lot of money to protect yourself from future rate rises. But you would have the peace of mind of not having to worry about what interest rates do over the next five years.
However, if interest rates continue to rise, you may end up paying even more. If mortgage rates hit 5% when you come to refinance in a year, you could end up paying £2,046 a month over five years, an extra £12,060 over the life of the product.
From this perspective, it might make sense to pay any early repayment charges and lock in a lower rate now.
Extra payments to reduce the loan
If you want to avoid early repayment charges, another option is to make smaller one-off payments.
Most mortgage lenders will allow you to overpay up to 10% of what you owe without triggering an early repayment charge. Paying off a chunk of your mortgage now while you are on a low rate will reduce the capital you owe meaning that when you do remortgage, you’ll need a smaller loan.
Another thing to consider is the fact that most mortgage offers are valid for six months. This means you can shop around for a new mortgage six months before your current deal ends. In an environment of rising interest rates, this is a great idea.
Get a mortgage application approved and you should be able to lock in a rate six months early, avoiding any more rate rises. If rates fall you can abandon that offer for a cheaper one without penalty.
Ultimately, deciding to break your mortgage deal and pay any early repayment charges to avoid possible future rate rises is a gamble.
You simply won’t know if it was a good idea until a year has passed and you can see what happened to interest rates. So, whether or not you do it will be a personal choice.
What we have seen in recent weeks is that the economic picture can completely change in just a few hours. And that can lead interest rate predictions to fluctuate hugely.
Rupert was the former Deputy Digital Editor of MoneyWeek. He's an active investor and has always been fascinated by the world of business and investing.
His style has been heavily influenced by US investors Warren Buffett and Philip Carret. He is always looking for high-quality growth opportunities trading at a reasonable price, preferring cash generative businesses with strong balance sheets over blue-sky growth stocks.
Rupert has freelanced as a financial journalist for 10 years, writing for several UK and international publications aimed at a range of readers, from the first timer to experienced high net wealth individuals and fund managers. During this time he had developed a deep understanding of the financial markets and the factors that influence them.
He has written for the Motley Fool, Gurufocus and ValueWalk among others. Rupert has also founded and managed several businesses, including New York-based hedge fund newsletter, Hidden Value Stocks, written over 20 ebooks and appeared as an expert commentator on the BBC World Service.
He has achieved the CFA UK Certificate in Investment Management, Chartered Institute for Securities & Investment Investment Advice Diploma and Chartered Institute for Securities & Investment Private Client Investment Advice & Management (PCIAM) qualification.
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