What are the pros and cons of overpaying your mortgage? Experts explain
WITH mortgage costs remaining high, many households are facing a tough choice: should they overpay their mortgage or not?
Over the lifetime of your mortgage, you can expect to pay back tens of thousands of pounds in interest, or even more.
But by overpaying, even by as little as £1.66 a day, you could save yourself thousands of pounds in the long run.
It sounds like a sensible decision – but there are important considerations to weigh up first.
We’ve quizzed the mortgage experts to find out the pros and cons of overpaying your mortgage, so you can make the right decision.
Understanding your interest
Most homeowners understand that the higher your interest rate, the more expensive your monthly mortgage payment will be.
What they may not realise is the impact an increase in rates can have on the total amount of interest they’ll be charged in the long run.
When interest rates were as low as 2%, borrowers with a £200,000 mortgage spread over 25 years would repay £54,357 in interest by the end of the term.
Now that average mortgage rates are higher than 5%, homeowners are facing an eye watering bill of £150,882 for the same size 25-year mortgage.
The length of your mortgage has a huge impact on the amount of interest you’ll repay overall.
For example if you take out a £200,000 mortgage over 20 years at an interest rate of 5% you’ll have paid back £116,876 in interest by the end of the term. At 25 years, this increases to £150,882.
If you’re one of the first-time buyers opting for a so-called marathon mortgage – 30 years or more – your interest bill will spiral.
A £200,000 mortgage at 5% spread over 35 years will cost you £224,133 in interest. That’s an increase of £73,251 for adding 10 years to your mortgage term.
Chris Sykes, technical director, Private Finance, said: “Many first-time buyers are stretching their mortgage terms over three or even four decades to make the monthly mortgage payments affordable.
“But this has a huge effect on the amount of interest they’ll pay back over the term of their loan.
“Remember, when you remortgage you can opt to lower the term if you have the budget or if rates have reduced and can overpay in the meantime if you have the spare cash.”
Is overpaying right for you?
If you’re still on a low fixed rate of 1% or 2%, you could earn a better return on your cash by putting it in a savings account.
The best easy access savings account rates are close to 5%. By saving your money instead of overpaying your mortgage, you could earn more interest than you’ll save on your debt.
When it’s time to remortgage, you can use your savings to pay off your mortgage balance.
Before you overpay, check the rules of your mortgage. Most mortgages allow overpayments of 10% of your mortgage balance every year. Some allow 20% or even more.
Check with your lender or broker to find out how much you can overpay.
Exceeding your overpayment cap will trigger an early repayment charge, a costly penalty that usually decreases for each year of your mortgage deal.
For example, if you took out a five-year fixed rate in year one your penalty for exceeding your overpayment allowance would be 5% of your mortgage balance. In year five of your deal this would be 1%.
You don’t have to overpay every month, Mr Sykes said.
“If you’re allowance is 10% overpayments each year, typically this can paid daily, weekly, monthly or annually,” he said.
“With the way that compounding works, where interest is added to the debt each year affecting the cost of your monthly payments, you are usually best making overpayments as soon as you can rather than saving for one big lump sum payment.”
Benefits of overpaying
The more you overpay your mortgage the less you’ll pay back in interest over the lifetime of your mortgage. You will also shave years off your mortgage term. Who doesn’t want to be mortgage-free as quickly as possible?
But there are other benefits too.
David Hollingworth, of L&C Mortgages, said: “If you’re lucky enough to still be on a rate of around 2% make that low rate work harder for you for the remainder of your fixed rate by overpaying as much as you can afford.
“That way, by the time your deal expires and you have to remortgage to higher rate you’ll have a smaller mortgage balance to contend with.”
If you’re on a fixed rate of 5% or more, overpaying your mortgage will give you a better return on a cash than putting it in a savings account.
And you’ll avoid the possibility of paying income tax on your overpayments, which may happen if you put the money in your savings account and your interest earned exceeds the Personal Savings Allowance of £1,000.
Overpayment drawbacks
You risk incurring a hefty penalty that would wipe out all your good work if you haven’t read the mortgage small print and pay back more than your overpayment allowance.
Always check with your lender or broker before you start to overpay.
Think carefully before you send your spare cash to your mortgage lender. There’s no easy access to your overpayments once it’s been deducted from your mortgage balance.
If you did need to get access to it, you’d have go through a remortgage or apply to your lender for a further advance, which is like a second mortgage.
One way to keep flexible access to your cash is to take out an offset mortgage.
An offset mortgage allows borrowers to link their savings to their mortgage account.
While you don’t earn interest on your savings, the value of your savings is deducted from your mortgage when calculating how much interest you must pay, making it cheaper.
You can take your savings out whenever you like but your mortgage payment will go up.
If you’ve still got a low fixed rate you may get a better return on your cash by investing it in a savings account instead. When it’s time to remortgage, you can use your savings to lower your mortgage balance.
Tips for overpaying
If you plan to pay the same amount regularly ask your mortgage lender to increase your direct debit so you don’t forget. It’s a good way to get used to paying a higher amount.
You can always ask for your direct debit to be reduced to its original amount in the future.
If you’re concerned you won’t keep up the good habit of overpaying, you can hard wire the overpayment into your home loan when you remortgage by reducing the mortgage term. This will automatically cause your payment to go up.
The downside is that there’s no flexibility to switch off the overpayment because you are now contractually obliged to pay it.
Don’t throw every penny at your mortgage. It’s just as important to have a rainy-day fund that can be easily accessed if needed.
Different types of mortgages
We break down all you need to know about mortgages and what categories they fall into.
A fixed rate mortgage provides an interest rate that remains the same for an agreed period such as two, five or even 10 years.
Your monthly repayments would remain the same for the whole deal period.
There are a few different types of variable mortgages and, as the name suggests, the rates can change.
A tracker mortgage sets your rate a certain percentage above or below an external benchmark.
This is usually the Bank of England base rate or a bank may have its figure.
If the base rate rises, so will your mortgage but if it drops then your monthly repayments will be reduced.
A standard variable rate (SVR) is a default rate offered by banks. You usually revert to this at the end of a fixed deal term, unless you get a new one.
SVRs are generally higher than other types of mortgage, so if you’re on one then you’re likely to be paying more than you need to.
Variable rate mortgages often don’t have exit fees while a fixed rate could do.