Anybody, who has a mortgage and has some savings or surplus funds is faced with the dilemma: whether to use the savings for overpaying the mortgage or whether to leave the savings untouched. Let's look at overpaying in detail and its advantages.
As you review this mortgage guide on mortgage overpayments you may want to use our Early Repayment Mortgage Calculator to help you calculate how much you can save on interest by making overpayments on your mortgage. The link opens the Early Repayment Mortgage Calculator in a new tab so you can review the guide and use the examples to help you calculate how those numbers could change your monthly mortgage repayments.
As a first step, you should remember that money has a cost known as interest. When you take a mortgage, you are buying money for a cost that is the interest rate charged by the lender. And if you are saving money you are lending it to the bank, which in turn will pay you an interest. Banks are in the business of money, and thus they make a profit by lending money. So, you will always find that the lending rate offered by the bank is always lower than the lending rate charged by banks. This is how banks earn their profit.
Example 1: You have a credit card debt of £2,000 at an interest rate of 18.9% p.a., which works out to an interest of £378 p.a. On the other hand, if you keep £2,000 in a savings account at an interest of 3%, you will get an interest of £60. If you have £2,000 in cash, it is a very easy decision to repay off your credit card debt rather than keeping the money in savings account as this can give you annual savings of £318 (£378-60).
A similar rule applies for your mortgage. If you are paying a higher rate on your mortgage than what you will earn through a savings account, you will be better off by overpaying the mortgage.
Example 2: If you have a mortgage at 5.9% per annum, unless you get a savings account that pays off more than 5.9% interest, it will be wise to overpay the mortgage.
Moreover, while calculating interest on savings account, you should take income tax into consideration.
Example 3: Let's say you are a basic taxpayer, who is paying 20% tax per annum. And you are paying interest of 4.9% on your mortgage. In such a scenario, you need a savings account that pays an interest rate of above 6.1% before tax. If you are a higher tax payer (40%), you need a savings account that pays 8.2% interest.
Needless to say, such interest rates on savings accounts are unheard of, which is why most people prefer to overpay their mortgages if they have the funds.
Overpaying of mortgage offers several advantages, as listed below.
Repaying your mortgage faster: A big advantage of overpaying is it allows you to repay your mortgage faster. That's because overpaying reduces the interest component in your monthly repayments.
Example 4: Suppose you have a mortgage of £250,000 at an interest of 5.9%, and you have 20 years remaining on the mortgage. Your monthly repayment will be £1,777. If you repay £25,000 to the lender, the repayment will have no impact on your monthly repayments, and you will continue to pay £1,777 each month. However, the interest component in the monthly repayment will be reduced. Thus, you will be paying more principal every month. By repaying £25,000, you will save interest of £48,365 over the lifetime of the mortgage. Also, you will be free of mortgage 3 years and 6 months earlier than the original mortgage term.
Overpaying a mortgage gives the best risk-free return than any other investment. Let's say if the interest on your mortgage is 5.9%. You will not find any other investment that gives this kind of a return without risk. There may be other investments that can give a higher return, but the risk in them is higher. Also, if you invest the amount saved in interest in a regular savings account, you can generate significant savings overtime. This way, not only will your house be free of mortgage earlier, but you will also have a decent amount of cash savings.
Overpaying gives a huge psychological advantage and can be a big morale booster. When you overpay, you know that you are less dependent on the bank. Some people may argue that a mortgage is not as bad as other debts such as credit cards or overdrafts. However, there is no such thing as a good or a bad debt. If you are hit by a financial crisis and you are struggling to make the monthly repayments, you will regret not overpaying the mortgage.
The one very important reason for not overpaying a mortgage is that if you overpay, you are putting all your eggs in a single basket. If you focus only on repayment of the mortgage without building any savings or keeping any reserve cash, at the end of a few years you will be left with an illiquid asset. And since you are using the property, so you won't be able to generate any money out of it. The only way you can liquidate the property is by selling it, and the process is quite complicated.
However, apart from this one reason, there are many positives of overpaying a mortgage.
While overpaying has many advantages, you need to ask some key questions before deciding to overpay.
If you secure a savings rate which is higher than your mortgage interest rate, it will be more beneficial not to overpay the mortgage. You need to check the best savings rates in the market and compare them to the rates you are paying on your mortgage. When comparing interest rates, it is important to evaluate the best savings rate in the market, and not just the savings rates offered by your bank or your building society.
Even though it may be beneficial to overpay a mortgage, you should take overpayment penalties into account. Many lenders charge a penalty for repaying a mortgage before the term. In particular, you are likely to pay an overpayment penalty if your mortgage is a fixed or discounted offer with a special rate for an initial incentive period. By charging a penalty for overpayment, lenders want to make sure you don't dump them for another lender once the incentive period ends. Nevertheless, most lenders allow a maximum overpayment of 10% every year without charging any penalty. However, it is always good to confirm with the lender because if the overpayment penalty is high, any benefit earned from overpaying the mortgage will be minimized.
The golden rule of debt repayment (whether mortgage or any other debt) is to prioritize paying the debts with the highest rate of interest. If you do so, you can minimize your interest payments and save more cash to clear off your other debts. Therefore, it is wise to pay off your credit card debts or any other debts like student loans that charge a higher interest before overpaying a mortgage.
No matter how many credit cards or debt options are available, it is always good to have some cash savings for any unforeseen emergencies. If you overpay your mortgage and don't have any cash savings, it will make you dependent on your card for emergencies, and you will end up paying much more than what you saved by overpaying.
As a rule of thumb, most people advise having cash savings worth 3 to 6 months of expenses before overpaying a mortgage. If you see an increase of cash flow, either due to a pay rise or some other windfall, it is wise first to build a cash reserve fund before overpaying a mortgage.
While some calculations may show you will be better off by overpaying your mortgage, you should check if there are any better mortgage deals available. It is possible that once you do the comparison using a lower mortgage rate, overpaying may not be as beneficial as before.
If you are overpaying a mortgage, it important to time your overpayment carefully. In order to get the maximum benefit from overpaying, you should know how frequently your mortgage lender calculates interest. Mortgage lenders may calculate interest either on a daily, monthly, quarterly or an annual basis. These days almost all mortgages charge interest on a daily basis. So you start getting the benefit of interest savings right from next day of overpaying.
But if your interest is calculated less frequently, say quarterly or annually, your timing of overpayment can have a big financial impact. For example, if you have an annual mortgage and you pay interest right before the annual interest calculation date, you can save on interest for the full year (next year).
As you have seen, you are better off by overpaying a mortgage as opposed to keeping the money in a savings account. However, there are other options that could turn out to be more beneficial than holding money in a savings account. We look at some of these.
Every year, you are allowed to save a certain amount in a cash ISA. In the 2014-15 tax year, you can save up to £15,000 in a cash ISA, and from the 2015-16 tax year you can save up to £15,240 in a cash ISA. Unlike a savings account, any interest earned on a cash ISA is tax free. This way you will earn an interest rate, which can more than the interest paid on the mortgage, or at least close to this rate.
If you don't put money in the cash ISA, you will lose the allowance for that particular year. For this reason, if the gap in interest rate is not too huge, and the cash ISA is paying slightly lower interest than your mortgage interest rate, it is worth saving some amount in a cash ISA. This way, you will make the full use of your ISA allowance, and also have liquid cash for emergencies.
By investing in a pension, you can get tax benefits, because the government adds to your pension contributions. And if you are a part of a company pension scheme, your employer may also contribute to your pensions. So if you have surplus cash, and you are not a part of any pension scheme, it will be a good idea to park some money in a pension fund and plan your retirement, instead of using all your funds on overpaying your mortgage.
The problem with savings account is that none of them give a tax-free return that is higher than the interest paid on a mortgage. If a basic taxpayer who is paying 4.9% interest on a mortgage can earn interest or a return of more than 6.1% on his savings, he can benefit more by saving rather than overpaying his mortgage.
However, any such investment comes with a higher risk as opposed to keeping money in a savings account. If you invest in a good investment that generates an 8 to 10% return, it is better than overpaying the mortgage. For instance, you may want to put your money in a unit trust and get a return of above 8%.
If a bad investment gives a much lower return than a savings account, and, worse, it wipes off your principal, you will regret the investment decision. There are no guarantees in investments such as stocks or property. The investment decision is entirely dependent on your risk appetite and your financial status. Also, there are no wrong and right investments. To quote billionaire investor Warren Buffet, "never invest in a business you can't understand." The same logic applies to investments. You should invest only in areas that you understand, including the risks and other market dynamics. Before making any investment decision, you should consult an Why use an Independent Financial Advisor?Independent Financial Advisor (IFA) and determine the best investment option for you based on your financial situation.
If you have enough cash to cover your expenses for 3-6 months, it is a good idea to overpay your mortgage. You will be free of debt sooner, plus you will get a big psychological and emotional relief.
Use our mortgage calculator for calculating mortgage repayments based on different mortgage amounts and different loan terms. You can also use our Early Repayment Mortgage Calculator to calculate the difference that mortgage overpayments would make to your current and future finances.