Should you overpay your mortgage?
Who wouldn’t want to clear their mortgage early?
Your mortgage is probably your biggest debt, so if you find yourself with money to spare you might consider making overpayments.
Clearing your mortgage early could leave you with more money to enjoy in retirement – but will it work for everyone?
This guide will take you through the ins and outs of overpaying, and help you to decide whether it's the right choice for you.
If you're not sure about some of the terminology around overpayments, visit our mortgage jargon buster.
Why make overpayments?
The main reason for overpaying on your mortgage is that, if you do it regularly, it can take years off the length of your mortgage.
Of course, this would also mean you'd pay less overall because you'd save on interest. For example:
- You have £100,000 of remaining mortgage debt at 3.5% interest, with 18 years left on your term.
- Making regular overpayments of £200 a month would mean you finish repaying your mortgage five years and six months early.
- You would also save £11,354 in interest.
Another benefit of making overpayments is that it increases the equity you own in your home, which can enable you to access better interest rates if you want to remortgage later on.
If you've got some money to spare and are thinking of putting it towards overpaying your mortgage, there may be more pressing priorities for your money. Answer these questions to check you've got all the bases covered.
1. Have you paid off all your more expensive debts?
It always makes sense to pay off your more expensive debts first. So if you have credit card debt with a higher interest rate than your mortgage, consider putting your spare cash towards this instead.
2. Do you have an emergency fund?
You should always have some savings in an instant access account, in case of sudden unexpected expenses. A pot of roughly three months' salary is usually a good target to aim for. Ensure that your emergency fund is well topped up before you put extra money towards your mortgage. (Some lenders will let you access the money you've overpaid if you need to, but others won't.)
3. Are you preparing for retirement?
It's crucial to start saving for retirement as early as you can. Since the introduction of auto-enrolment in 2012, most people will now have the option of joining a company pension scheme. But if you're self-employed (or just want to save more), consider starting a personal pension. In the grand scheme of things, putting spare money towards a pension could be more important than overpaying on your mortgage, especially if you aren't already making arrangements to fund your retirement.
4. Could your family cope financially without you?
It may be unpleasant to think about, but if you have dependents, what would happen to them financially if you were to die? Could your partner make the mortgage payments without your salary? Using spare cash to pay for a life insurance policy could be sensible.
If the answer to these four questions is yes, then you could be in a position to overpay on your mortgage.
Let's go into more detail about what this might mean for you.
Does your mortgage allow overpayments?
Most lenders will allow you to overpay up to 10% of the outstanding mortgage debt each year without penalties, but check the details with your lender. If you overpay without checking the terms of your deal first, you could face charges that outweigh the benefits of overpaying.
Could you remortgage instead?
Compare today's UK remortgage offers and see what your new monthly payment would be.
Some lenders will have a minimum overpayment amount. If you overpay by less than this amount, the money sits in the lender's account until the end of the financial year, meaning your outstanding interest isn't recalculated until then. Paying above the minimum amount will ensure that your interest is recalculated from the next month, saving you money in the long term. Some also have a maximum overpayment amount, with penalties incurred for payments above the threshold.
Watch out: Some lenders will allow you to overpay, but will shorten the term of your mortgage deal if you do. This effectively locks you into the higher payments for the duration of the term, which may not be affordable for you in the long run. They could also reduce your usual monthly payments, which means you're not really overpaying at all (because you're not saving on interest). If your lender will do either of these things, it's probably not worth overpaying.
Should you use a lump sum to overpay your mortgage?
If you've got a lump sum to play with and your emergency fund is healthy, you might want to make a one-off overpayment on your mortgage. However, you could be better off saving or investing the money instead.
The table below shows the potential benefits of saving or investing vs making overpayments, based on a lump sum of £6,000 or regular monthly payments of £100 for five years.
We've assumed a mortgage interest rate of 3%, a mortgage debt of £150,000, a cash savings interest rate of 1.25% paid annually, and an investment growth rate of 6% (7% growth with 1% subtracted for charges).
The "return" shown for a mortgage overpayment is the amount of money saved in interest.
For a basic rate taxpayer:
For a higher rate taxpayer:
So if you have a lump sum and are only a few years away from retirement (and/or the end of your mortgage term) you could benefit from using the money to overpay on your mortgage. Shortening your mortgage term by a year could make a big difference to your finances as you approach retirement.
However, if you've got the time for your money to grow, you could see a better return by investing your lump sum in order to top up your retirement fund. Remember that any investment involves exposing your money to risk, and returns are not guaranteed.
Making regular overpayments
We've looked at the effects of using a lump sum to overpay, but what about overpaying a smaller amount each month in the longer term? Assuming that your finances are in good shape as outlined above, you could consider putting an extra £100 or so towards your mortgage each month.
If you have a mortgage debt of £150,000, at an interest rate of 3.5% with a 25 year term, overpaying by £100 each month would save you £14,396 in interest, and clear your mortgage four years and four months early (assuming your rate stays the same). However, you need to consider whether you can afford to maintain the overpayments in the long term.
Remember that overpaying in this way will usually shorten the term of your mortgage, which could leave you vulnerable to early repayment charges (ERCs) when you clear your mortgage debt. Check the terms of your mortgage carefully before you proceed.
Taking advantage of low rates
Although paying an extra £100 per month towards your mortgage may not be affordable for the duration of your term, it could be beneficial for a short period while interest rates are low. If your current monthly payments are low enough for you to afford it, overpaying now will help you to build up equity in your home more quickly, reducing the term of your mortgage. Owning more equity could also put you in a better position if you intend to switch to a fixed rate deal, in order to protect yourself from a rise in rates.
While savings rates remain low, this could be a better use of spare cash than a savings account (as we saw in the tables above).
Could you remortgage instead?
Before you decide to make regular overpayments, you should consider whether your current mortgage deal is competitive. You may be able to save more by switching to a better deal. Compare the best remortgage deals and see whether you can save on interest without increasing your monthly payments.
Last updated: 28 September 2015