Something that many people consider at some point in the lifetime of their mortgage is whether they should make overpayments to reduce the outstanding balance.
There are a lot of reasons that this could be a good idea, however also a lot to consider as it might not be the best use of your funds depending on your circumstances.
Whilst we are unable to specifically recommend and provide advice on what is best for individual situations, we thought we’d lay out some of the advantages and disadvantages along with a couple of alternate options that could be considered.
We trust you find this article helpful!
Advantages to Making Mortgage Overpayments
- Debt Reduction and Interest Savings
Making overpayments on your mortgage has the clear benefit of reducing your outstanding debt, bringing you closer to a mortgage-free future. What may be less apparent is the concurrent reduction in interest payments.
Consider this scenario:
You have a 20-year mortgage of £150,000 with a 6% interest rate. If you make a lump sum overpayment of £15,000 (equivalent to 10% of the outstanding balance), you could end up paying off your mortgage in two years and seven months earlier than expected. Additionally, you’ll save £29,600 in interest over the life of the loan.
- Cost Savings Over Savings Accounts
Overpaying your mortgage can offer a more attractive return on investment compared to keeping your money in a savings account.
For instance, if you place the same £15,000 in an easy-access savings account with a 4% interest rate, you’d earn £600 annually.
When you weigh this against the £29,600 in interest saved by overpaying the mortgage, the latter becomes a more compelling choice.
- Improved Mortgage Deals
Overpaying on your mortgage can lead to a decrease in your loan-to-value (LTV) ratio, reflecting the proportion of your property’s value covered by your mortgage.
As your property value increases and you pay down your mortgage balance, your LTV decreases. This is significant because lenders often use your LTV to determine the interest rates they offer.
A lower LTV may translate into better mortgage deals when you decide to remortgage.
Disadvantages of Making Mortgage Overpayments
- Potential Penalties
Many fixed-rate mortgages come with an initial tie-in period during which early repayment may result in penalties.
Overpaying your mortgage during this period can trigger Early Repayment Charges (ERC), typically ranging from 1% to 5% of the outstanding balance.
For example, with a £150,000 mortgage, a 1% ERC would amount to a £1,500 penalty. However, with a smaller mortgage, like £50,000, a 1% ERC would only set you back £500, making it a potentially worthwhile trade-off if it significantly reduces your balance and interest payments.
It’s important to note that most lenders permit overpayments of around 10% per year during the tie-in period. Still, it’s advisable to review your mortgage terms before making overpayments.
- Restricted Access to Cash
While reducing your mortgage debt is a commendable goal, maintaining access to emergency funds is essential.
Unforeseen events can occur, as demonstrated by the recent pandemic, making it crucial to have three to six months (or ideally 12 months) of post-tax income readily available.
However, this may not apply if you have a flexible mortgage, such as an offset or current account mortgage, which allows you to borrow back funds you’ve overpaid, ensuring you won’t be short of cash if you make overpayments.
Alternatives to Mortgage Overpayments
If you’re uncertain about overpaying your mortgage, consider these alternative strategies:
- Pursue Better Savings Rates
Explore savings accounts offering rates exceeding 4%, and consider fixed-rate options, even though they restrict access to your funds.
- Prioritize Paying Off More Expensive Debt
While your mortgage might be your largest debt, other debts like credit cards, unsecured loans, and overdrafts often carry higher interest rates. Financial wisdom advises tackling these debts first.
- Boost Your Pension Savings
If you have surplus cash, investing in your pension can be a sensible choice due to tax relief and potential growth. There’s no limit on how much you can contribute to your pension, but you can receive tax relief on up to 100% of your salary or £60,000.
When in doubt, it’s advisable to consult with a mortgage broker. They can provide a comprehensive overview of your options and assist you in identifying the suitable financial solutions.