According to a 2016 survey, Brits reach an average age of 69 before they become mortgage and debt-free.
Do you want to be mortgage-free before you retire? If so, overpaying on your mortgage is one way for you to repay your home loan more quickly.
But what are the advantages of overpaying on your mortgage? Is it better to overpay or to save the money? And can you reduce your mortgage term?
Is it worth overpaying your mortgage?
There are two main reasons that you might want to consider mortgage overpayments. You could repay your loan more quickly, or reduce your mortgage term.
Overpaying on your mortgage can result in you paying less interest and shorten your mortgage term. Here’s an example from Citywire:
Let’s assume that you have a £200,000 mortgage over 25 years on a rate of 2%. On this deal you’d pay £848 per month for the next 25 years, assuming you stay on the same interest rate.
If you decide to overpay your mortgage by £200 a month, you’d pay a total of £1,048 each month. Doing this would mean you pay off your mortgage three years and three months earlier and it would save you £7,648 in interest over the term of your mortgage.
While there are often lots of financial reasons to overpay, there are also emotional reasons to consider. Perhaps you’d feel more secure if you owned your home outright? Or perhaps you have a cautious attitude to investment risk?
Often making the decision to overpay is more than simply a financial one.
How do I overpay on my mortgage?
Mortgage overpayments are any additional amounts that you pay above and beyond your contractual monthly mortgage repayment. Most mortgages will allow you to make overpayments, monthly or as a lump sum.
As most mortgages are paid by direct debit (with this amount based on your contractually agreed payment) you may have to contact your lender if you want to increase the amount that you pay. Always check with your lender that any amount you overpay comes off your mortgage balance straightaway.
Your alternative option is to pay lump sums off your mortgage. Most lenders will let you pay a lump sum off your mortgage, although the minimum lump sum amount might change from lender to lender.
Be careful also that you won’t incur early repayment charges for making an overpayment. If you’re on a fixed or discounted rate, you may face a penalty if you pay a lump sum. Most mortgages allow you to repay 10% of the outstanding balance every year without penalty.
When you have paid off a lump sum, check that your lender hasn’t simply reduced your regular repayment. If you want to carry on paying the same, you need them to reduce the mortgage term.
Should I save, or overpay my mortgage?
You should make sure you have a cash emergency fund before committing your savings to your mortgage. Once you overpay on your mortgage it can be hard to re-borrow those funds, so make sure you have three to six months’ worth of bills in an easy-access savings account.
If you do have savings, then overpaying can offer financial benefits when compared to saving. Here’s an example.
Assuming your mortgage rate is 5%, you would save £500 a year in interest if you overpaid a lump sum of £10,000. To earn the same amount from savings, a basic-rate taxpayer needs an account paying 5% (assuming you don’t earn more than £1,000 of savings interest each year). If you’re a top rate taxpayer you would need a savings account paying 9.1%.
Considering that savings rates are low, overpaying will often save you more in interest costs than the interest you will earn on a savings account.
Another option is to consider an offset mortgage, where you can both save and overpay on your mortgage monthly.
Under an offset arrangement, your savings account is linked to your mortgage. Money held in the savings account are taken off – or offset against – the mortgage balance. This means that you're only charged interest on the mortgage balance minus your savings balance. While you don’t earn any interest on your savings, you will reduce the amount of interest you pay on your mortgage. Additionally, your savings remain available in case you need to withdraw them.
Should I pay off my mortgage or invest into a pension?
Everyone’s circumstances are different, and so you should seek professional financial advice when considering overpaying your mortgage monthly or as a lump sum, or saving into a pension.
Remember that paying off a mortgage gives a guaranteed return, while using the cash for investing may mean huge returns or losses.
Daily Telegraph personal finance expert Richard Dyson says: “I won’t rehearse all the risks associated with borrowing to invest, except to say again that it breaks rule number one of personal finance: first clear debts and then build savings.”
Early mortgage payoff – the pros and cons
There are both pros and cons for you to consider when you are thinking about paying off your mortgage early:
Pros
- You will pay less mortgage interest overall.
- You may reduce your mortgage term.
- You benefit from the security of owning your own home outright. Paying off your mortgage in full can give you the peace of mind that your home is your own.
Cons
- Your lender may have a limit on overpayments and you may incur penalty charges for overpaying.
- You may have debts that are more expensive than your mortgage which could ultimately cost you more.
- Committing your savings to repay your mortgage makes the cash much harder to get hold of should you need it. Think about your situation and the cash you have available for emergencies before paying money to your mortgage.
Does overpaying my mortgage reduce the term?
Yes, it can. Normally, making a mortgage overpayment gives you two options:
- Reduce your monthly repayments
- Reduce the mortgage term
The shorter the term of your mortgage, the less interest you pay overall. Your existing mortgage lender may allow you to reduce your term once you have made an overpayment.
The side effect of a shorter term will be higher monthly repayments. Be careful not to put yourself in financial trouble by committing to mortgage payments which you may struggle to maintain in the future.
Is it better to overpay mortgage or reduce term?
This depends on your personal circumstances. Reducing your term will commit you to higher monthly repayments which you will be contractually obliged to pay. If you think you will be able to maintain these higher repayments, then this is an option you can consider.
Making overpayments gives you more flexibility as you can change the amounts you overpay. If you want to retain the ability to increase or decrease your overpayments, then this may be a better route to take.