The pros and cons of overpaying your mortgage
Making our way onto the property ladder is one of the most exciting moments of our lives. Finally, the money we earn each month is actually paying off our home, rather than going into a landlord’s pocket. With just a deposit behind you, and a probable high loan-to-value (LTV) percentage of 80-90%, you might not be able to think of paying off any more than the minimum each month.
However, when it comes to remortgage time you may have a little more scope to set the conditions that suit you. You’ll have built up some equity, and therefore your LTV will be lower. You might have more money behind you. Maybe you’ll want to pay off the mortgage as quickly as possible, so will be happy paying more per month. Alternatively, you might wish to spread payments out and spend your money on life.
However, there is another option – overpaying your mortgage. Essentially this is an additional amount that you can pay each month on top of your mortgage, which is optional – if you don’t want to pay anything you don’t have to. However, in effect it works as a savings account as much as a payment, in that you’re eroding the interest rate of your mortgage.
Low interest rates
With savings account interest rates at historic lows, based on a Bank of England base rate of just 0.25%, there’s not really much point in leaving your money in the bank from a strictly financial viewpoint. Rather, paying off the higher interest rate of your mortgage would surely be the more logical choice, simply because the money you’ll eventually save on your mortgage will more than offset the money you’ll make from saving. However, if there are other debts that are sapping your funds, such as loans or credit cards, these should be tackled first, because the reverse will be true. Remember, there’s no interest on the amount you overpay.
Additionally, the more you overpay, the less of a shock it will be, if and when interest rates eventually do rise – simply because there will be less of a mortgage owed on which lenders can charge interest.
Mortgages are a money-maker for lenders. Homeowners borrowing tens or hundreds of thousands of pounds with a juicy interest rate are usually a fairly low-risk investment over a steady period of time, presuming the lender has carried out due diligence. For that reason, mortgage lenders don’t want to go through the effort of setting up a mortgage for someone to pay off huge chunks early. So they set up a maximum overpayment, with penalties if someone goes above this. It might be a percentage of the mortgage, or a set figure such as £1,000 a month, or a value per year.
A typical overpayment punishment could be up to 5% of the amount being overpaid. That might not sound a lot if you’re paying monthly – a £2.50 fine on a £50 payment isn’t going to break the bank. However, if you save up and overpay a lump amount each year, of several thousand pounds, you could face a fine of several hundred pounds. So be careful if you’re planning overpayments – contact the lender beforehand if you’re unsure whether punishment will ensue.
Mark Harris, chief executive of mortgage broker SPF Private Clients, said: ‘Most lenders will let you overpay on your mortgage by up to 10 per cent of the mortgage amount per annum without charging you a redemption penalty for doing so, but this can differ from lender to lender so it is worth checking before making any overpayments. This is a standard offering to all customers so does not depend on your individual circumstances such as your credit rating.”
Imagine that you’ve got a spare £500 in your account that you’ve decided to put towards your mortgage. One day after you make your overpayment, which you did with the best of intentions, your car’s engine develops a serious problem. Repairs will cost you £500, which you no longer have. You’re then plunged into debt via a credit card, paying a high rate of interest. The day after that, your boiler goes wrong, leading to a bill of £200. And so on. That said, some mortgages have ‘flexible features’, which allow you to borrow back money without penalty.
This is perhaps an extreme example, and assumes that you’re paying out several hundred pounds per month. In fact, even an overpayment of £20-50 a month will pay dividends. As an example, a 25-year £150,000 mortgage with an interest rate of 4% could be trimmed by six months and £2,095 of interest, with just an extra payment of £10 a month. A £50 overpayment would reduce it by 29 months, and £9,521 of interest.
Harris, said: ‘Reducing your mortgage is always a good idea but before you do overpay, clear more expensive debt on credit and store cards, as those will be costing you more. Also make sure you have a contingency fund of six months’ worth of funds in an easy-access savings account.’
The final advantage of overpaying is that it will lead to better deals when you come to remortgage, because your LTV (loan to value) will be better. Simply put, the more you need to borrow, the worse your interest rate offer will probably be. As an example, let’s take two people who’ve both purchased homes at the same time, each costing £125,000. Andrew and Bob both have a deposit of £25,000 and both get offered the same terms. However, one decides to overpay by a few hundred pounds a month, while the other sticks to their minimum mortgage payment.
After three years, Andrew owes £94,000, and Bob owes £87,000. It now means, at remortgage time, that one owes 75% of the total home value, and the other owes 70%.
There’s a very real chance that Bob will have a larger range of lender products to choose from, with some at lower interest rates. He doesn’t need to take them, and they might not be quite right for his circumstances – but the option is there, purely because his overpayments knocked down the total at a faster rate.
John Baker is a freelance writer focusing on financial and economic advice