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4 Managing your mortgage: overpaying

The previous section covered how paying off your mortgage can be accelerated by using ‘offset’ and ‘flexible’ mortgage products. It was also noted how conventional mortgages can offer the ability to make overpayments, pushing down the balance left to pay off.

This shows a montage of bank notes and coins, a calculator and small plastic toy houses sitting on piles of coins.
Figure 4 Should I make overpayments?

The maths behind this is quite simple if you have spare income each month – it comes down to a comparison between the mortgage rate and interest rate you could get if, instead of overpaying, you placed the money into a savings account. If the mortgage rate is higher than what you can get on a savings product the answer appears to be a ‘no brainer’: pay down the mortgage rather than save the money.

There are, though, a few things you need to be aware of before opting to overpay:

  • Does your mortgage contract allow overpayments and, if so, by how much? 10% of the balance per year is a standard figure, but if you go beyond any limits for overpayments you could incur early repayment charges, particularly if you’re on a fixed-rate or discount mortgage.
  • If you do use your savings to make an overpayment, check if there are any charges for withdrawing money from your account.
  • Do you have other debts (e.g. a bank loan) with a higher interest rate than the mortgage rate you are paying? If so, using your savings to reduce or pay off these debts would make more sense than reducing your mortgage balance.

Activity 4 Should I overpay my mortgage?

Timing: Allow approximately 5 minutes

Imagine the following scenario. Your mortgage has three years left before you complete repayments. The mortgage rate is 3.2% per annum but you earn 1.8% per annum on your savings in a fixed-rate ISA account. If you withdraw money from the bond account before maturity, you pay a charge of 6 months interest. Leaving aside any other considerations, is it worth using money from your bond account to overpay your mortgage?

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Yes, it’s still wise to overpay the mortgage. The loss of earnings on the fixed-rate ISA account is 1.8% interest. The one-off charge is 0.9% (= 6 months, or one half, of the annual interest of 1.8%). But this cost can be spread over the remaining 3-year life of the mortgage and so equates to 0.3% (0.9% ÷ 3) per year. That totals 2.1% (1.8% + 0.3%) of lost earnings per year against the 3.2% of interest that will be saved by reducing the mortgage balance.

Note that these calculations ignore the very small amounts of interest earned on previous interest paid (known as ‘compounding’). However this does not affect the conclusion that overpayment makes sense.

But remember that this is a mathematical exercise, where other considerations have been ignored. Ideally, you’ll not have other debts, you’ll have other savings you could fall back on if there was an emergency or you lost your job, and you’ve checked your mortgage allows overpayments.

While it can be the right decision to use savings to overpay your mortgage, be careful. It’s often better to overpay each month with surplus income (if you have it) rather than cashing in your savings and putting them towards a mortgage when you probably won’t be able to get the money back if you find you need it in the future.

Even if the maths points to overpaying your mortgage, should you use all your savings to reduce your mortgage balance?

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This would be unwise unless your mortgage has an easily accessible borrow back feature. Everyone should retain some savings to cover life’s emergencies and uncertainties. One recommendation is that these savings should be equivalent to what you’d spend over six months.

If you’ve used all of your savings, you may have to borrow money at short notice if something unexpected happens – like if your car breaks down or if your washing machine needs replacing.

The next section looks at when and why it makes sense to change your mortgage product and maybe your mortgage provider too.

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