Should I Overpay My Mortgage

INTRODUCTION • HOW OVERPAYMENTS WORK • COST SAVINGS • OFFSET MORTGAGES • ADDITIONAL CONSIDERATIONS • WHEN TO OVERPAY • REMORTGAGING • DECISION FRAMEWORK • SUMMARY

Introduction

If you have taken out a mortgage and can't stand the sight of a large chunk of you life passing till it's paid off, you're not alone. Many people choose to pay more than their minimum payments to their provider but there are some caveats that mean this doesn't work for everyone. Read on to see if this could be a good option for you.

How Overpayments Work

I'll use an example and a chart to explain this. Say you have taken out a £200,000 mortgage over a term of 35 years, which isn't that rare as houses become increasingly unaffordable. If you've got an interest rate of the current nationwide offering of around 4.5% you will be paying £947/month. This brings the total amount you pay, including interest, to £397,740, assuming that the interest rate stays the same for the 35 years and it looks like the following:

By paying more than the required £947 each month, you are reducing the term of your mortgage and there is less window for the bank to charge you interest. If you decide to make a monthly overpayment of just £50. the loan will be completed within 32 years:

If you have a bit more cash or get a pay rise you could direct money to this instead of lifestyle inflation. By making a monthly overpayment of £353, the loan will be completed within 20 years:

Doing this is great from your perspective but not so much for the lender. Because of this, there are often limits on how much you can overpay in a given year. It's often capped at 10% of the initial loan value so in this example, is £20,000 per year or £1666.66 per month on top of the minimum £947.

Cost Savings

As in the example above the total payments over 35 years is £397,740, a massive £197,740 bill in just the interest. The aim of overpayments, alongside the mental security of "I own my home and no one can take it" coming a lot sooner, is that by shortening the term, you pay less interest. If you take the extra £50/month route you will pay a total of £370,884, making savings of around £27,000.

The loan will be paid off in 31 and a bit years but I'll go with 31 to keep it simple, that means there are 4 years when you are not paying off the mortgage. By adding up the compulsory and overpayments over the 31 years you get £370,884. Taking the difference between that and the £397,740 gives the £26,856 savings.
Using the same logic for the extra £353/month gives the total payments at £312,000 will save you a huge £85,740 interest!

Offset Mortgages

A relatively unknown but potentially useful option is an offset mortgage. These allow you to link your current account and/or savings account to your mortgage company. The amount in your account will be used to offset the mortgage. If you have a £200,000 mortgage and have £20,000 in your savings and current account combined, the difference is £180,000 and that is the amount you would pay interest on instead of the £200,000. This allows you to maintain access to your money should you need it while getting the same benefits as you would get if you locked it away in a mortgage overpayment. There are a few downsides though:

1. You are unlikely to earn any interest on your savings while they are linked to your mortgage.

2. Higher interest rate than a non-offset mortgage.

3. Not all lenders offer them.

If you're a higher-rate taxpayer with substantial savings, offset mortgages can be more tax-efficient than earning taxable interest on savings while paying mortgage interest.

Additional Considerations

Correct Use:

The final point for this section is that if you do decide to overpay you need to make sure that it is to reduce the capital and reduce the term. Some providers default to "saving it up" so you can underpay in the future, this is not what you want. Another default is that you want to keep the length of the loan and reduce your monthly payments, that is also not what I'm talking about here.

Savings Accounts vs Overpaying:

Depending on when you took out your mortgage and if you got a fixed rate will largely define your interest rate. If your fixed mortgage rate is lower than current savings account rates, you'll benefit more by keeping your money in savings rather than overpaying, since money will grow there faster than it would shrink your mortgage. For example, if you can put your cash into a high interest savings account that pays more than your mortgage's interest rate (as a percentage), then it makes the most financial sense to put your money there instead of overpaying. Alternatively, if you can find a fixed term bond that could also pay better, and you're not going to need the money in the meantime, that could be a good option. If you have a bit more of an appetite for risk (and a longer time horizon), you could put it into the stock market to target even higher returns, which would most likely beat your mortgage interest rate.

Charges:

As I said before, there may be overpayment charges, for Nationwide any mortgage reserved on or after the 29th of May 2013 will be subject to charges if there is an annual overpayment on more than 10% of the initial loan. You should be able to find your specific limits in your mortgage documents and there are some cases where they don't apply. I won't go into them here since that would not make for very good reading, however they should be available on your providers website.

Liquidity:

Another thing to consider is the loss of liquidity, if you hold cash it's very easy to pay for a medical bill or a new boiler. If that cash is sent to your mortgage company you will not be able to get it back so will have to dip into a safety buffer or worse, a loan, to pay unexpected bills. If you don't yet have an emergency fund I recommend you read this article.

Inflation:

Generally inflation is seen as a bad thing but if you have a large loan whose interest is less than inflation it's not as bad as it seems. Say you have the £200,000 loan from before and inflation is sitting at 10% (not that far behind us), over 1 year your loan will still have the number 200,000 but the value of £200,000 will really be £180,000 in old money (the value of money before the inflation). Comparing those means that your loan has gone down by £20,000 just because the value of 1 pound is decreasing. Fixed mortgage payments become easier to afford as your salary rises with inflation, while the debt's real value decreases.

When To Overpay

There are a few conditions I would associate with someone who would benefit from making over payments.

Retirement:

Someone who is close to retirement is likely to see their income drop so may be less able to meet their mortgage payments. If you are around 10 years from retirement, you are likely to be making more than you ever have so this could be the best time to really cut your mortgage down in preparation for living off your investments and making them last as long as you do.

Maximised Tax Efficient Accounts:

There is a limit on how much you can contribute to an ISA and pension each year, take a look here and here to find out more. If you have maxed out each of these and don't know what to do with the remaining cash you have. a good option could be to make overpayments. There are other things you can do but that's not for this article.

Low Risk Tolerance:

Someone who has a low risk tolerance would benefit since this gives a guaranteed return equal to your interest rate. Also, you do have to live somewhere so you may as well fully own the deeds sooner rather than later.

Remortgaging:

A good option is to remortgage when your current deal ends, this typically happens when you move onto a variable rate. There are reasons why you should remortgage and reasons why you shouldn't. let's have a look at them now:

Reasons To Remortgage:

1. You can get a better rate elsewhere, who wouldn't want a better rate.

2. You want to borrow more, this can also coincide with purchasing a larger house.

3. The value of your house has increased a lot, this may move you to a lower Loan To Value (LTV) band giving you cheaper deals.

4. You think interest rate will increase. If you think they'll increase you may want to lock in a rate before that happens.

Reasons Not To Remortgage:

1. You've recently become self employed, this can work against you as lenders will want more proof of earnings if you are self employed so this could be hard if you have just started.

2. The value of your house has decreased. If you end up with a lower LTV or negative equity, you will often have to "top up" your deposit if you want to get a new mortgage since lenders will see you as riskier.

3. Your credit score has had problems since your first mortgage was secured. This will result in you being charged a higher rate.

The LTV is a way to quantify the amount of the house cost that your mortgage has to cover. This is the amount you paid for the house minus your deposit. The LTV bands are 60%, 75%, 85%, and 90%.

By overpaying before your term ends, you can reduce your LTV, potentially moving you into a better rate band (lower is better) when you remortgage.

Decision Framework

1. The first step is to determine if you have the cash to overpay and if not, do you want to overpay enough to give up something else to finance it. remember that just £50/month can take a few years off a mortgage. Decide how much you can afford to put into the overpayments, it doesn't have to be consistent as you can start and stop as and when you have the cash available.

2. Check if you have any expensive debts, there is a high chance that these should be cleared first, you can find more information here.

3. Now compare the interest you pay on your mortgage and see if you can find a saving account that will give you a higher interest. If you can find one, that is where you should put your money, if you're happy to take more risk, you could put in into the stock market which will likely give you better returns in the long run. If you cannot find one you may want to start overpayments.

I took out a 10-year fix at a low rate. Because I can earn more in an easy-access savings account, I save monthly and will make a lump-sum overpayment just under the 10% penalty threshold before my fix ends. This protects against future rate rises while maintaining flexibility.

Summary

Whether you should overpay depends on your mortgage rate, alternative investment returns, and personal circumstances. An overpayment can be a powerful way to decrease the time till you own your property outright. There are a few pitfalls like overpaying too much and incurring fees or being able to make more elsewhere but careful consideration could give you huge benefits.

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Disclaimer

The usual disclaimer: I'm just a guy on the internet sharing what I've learned. This isn't financial advice so do your own research and speak to a qualified adviser about your specific situation.