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.
The maths behind this is quite simple – 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:
Allow approximately 5 minutes
Your mortgage has three years left before you complete repayments. The mortgage rate is 3.2% per annum and 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 interest. The one-off charge of
(= 6 months, or one half, of the annual interest of
). But this cost can be spread over the remaining 3-year life of the mortgage and so equates to
per year. That totals
of lost earnings per year against the
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.
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 at least £500 per person in the household. 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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