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BLOG: Should you overpay your mortgage or invest spare cash?

Paloma Kubiak
Written By:
Paloma Kubiak

Interest rates have risen and the era of low cost borrowing may be coming to an end. Should you make mortgage overpayments or channel spare cash towards investments or your pension?

Getting a mortgage as a first-time buyer, securing a big enough mortgage for the home you want as a second-stepper and then paying off your mortgage before retirement are all huge financial challenges.

Given how stressful and costly mortgages can be – they’re the biggest monthly outgoing in many households – it may come as a surprise to learn that for the past 15 years, mortgages have been exceptionally ‘cheap’ compared to history.

Throughout the 1970s and 1980s it was common for lenders to charge up to 16% interest on mortgages, but in the decades since, the cost of borrowing has fallen.

Lenders use the Bank of England’s ‘base rate’ as a guide for setting interest rates on mortgages, credit cards and loans.

The Bank kept the base rate under 1% for just over 13 years from 2009 until June 2022, and lenders passed this on to consumers with historically unprecedented low rates on mortgages.

However, stricter lending rules – which may have included factors such as salary requirements or affordability checks – and high property prices have meant it’s been tough for people to borrow enough on a mortgage to buy the home they want. But that doesn’t erase the fact that some homebuyers are paying the lowest rates of interest ever seen!

What is your current mortgage interest rate?

If your fixed-rate mortgage deal is coming to an end this year, you may find remortgaging rates are higher than what you have been offered previously. Even small increases to mortgage interest rates can mean paying back far more money overall, so making overpayments to a mortgage now at a lower interest rate could be sensible.

Overpayments also reduce the overall amount outstanding, and when you come to remortgage, having a lower loan-to-value ratio could mean being offered a more competitive rate of interest.

Make financial decisions based on your circumstances and goals

You may have heard predictions that the era of low interest rates is coming to an end. The Bank of England has repeatedly raised the base rate and it reached 4.25% in April 2023, which means it’s back within the ‘normal’ range of 3.5% and 6% where it was between 2000 and 2008 (the Bank of England slashed it to 0.5% during the financial crisis in 2009). If the Bank keeps the base rate within the range for an extended period, the cost of borrowing would likely return to higher levels too.

Not all economists expect this. For example, the International Monetary Fund (IMF) forecasts that the Bank of England will cut rates back to the very low levels where they’ve been for the past 13 years, once inflation is under control. There’s no certainty over whether this will happen, or when, and regardless of whether interest rates rise or fall, everyone needs to make decisions based on their own circumstances and financial goals.

How are your retirement plans going?

Making mortgage overpayments can bring forward the day when you become mortgage-free, which will free up more of your income to channel towards pensions and other investments.

Contributions to a pension receive tax relief at 20%, 40% and 45% depending on your income tax bracket. Making additional contributions means benefitting from additional tax relief – although there are limits to how much each person can pay into a pension tax-efficiently, called the ‘annual allowance’.

Paying more into a pension at an earlier age is also beneficial because the money has longer to be invested, which can increase the chances of good returns. Money paid into a pension can also benefit from compound returns, where future returns are made on top of previous returns, which helps swell the size of the pot.

Weigh up whether spare cash is better put towards overpayments on a mortgage, a pension or split between the two – there’s no one-size-fits-all answer.

It’s important not to put all your eggs in one basket

Brits have a tendency to view property as the ideal investment since there has been a boom in house prices over the past 30 years. But you should never assume that past good performance of an asset will continue in future.

More recently, property prices have been stagnant or even fallen slightly in parts of the UK, which highlights the danger of viewing homes as the only investment worth having. Capital accumulated in a property can only be accessed through lengthy, costly processes such as selling, equity release or remortgaging.

Before making overpayments to your mortgage, consider whether you will need the money in the coming years. Savings held in cash or stocks and shares ISAs can often be withdrawn at short notice while the interest and investment returns built up are tax-free. Bear in mind that money from a pension can only be withdrawn at a Government-mandated age, which is 55 years old currently but rising to 57 years old for younger generations. There are also tax rules to abide by; you usually can’t just withdraw the whole lot tax-free!

Everyone wants to make the best use of their money and respond appropriately to the current economic environment, but it’s important to balance your own needs or goals with external circumstances. Without a crystal ball, it’s impossible to say whether overpaying a mortgage or investing is the ‘best’ choice for you, but it is possible to determine which will bring you closer to reaching your financial goals.

Annabelle Williams is personal finance specialist at Nutmeg – YourMoney.com’s Investment Awards 2023 winner in the Best Investment Platform for User Experience category