Understanding mortgages
Understanding mortgages

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Understanding mortgages

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.

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:

  • Does your mortgage contract allow overpayments and, if so, by how much? If you go beyond any limits for overpayments you could incur early repayment charges particularly if you’re on a fixed-rate mortgage.
  • Are there any charges for withdrawing your money from your savings account to make the overpayment? These commonly apply to early withdrawal from ‘notice accounts’ and fixed-rate bond accounts. These charges might make mortgage overpayment a costly move – although a key mitigating factor is that the withdrawal charge is a one-off cost and not an annual loss of interests. As such the charge can be spread out across the rest of the term of the mortgage.
  • There are complications too if you use money from a variable rate savings account to overpay on a fixed-rate mortgage – interest rates could rise subsequently meaning that you lose out on higher earnings from your savings.
  • If you use money from an ISA set up in an earlier tax year, you will not be able to use future savings to take advantage of that previous year’s ISA allowance.
  • 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

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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Discussion

Yes, it’s still wise to overpay the mortgage. The loss of earnings on the fixed-rate ISA account is 1.8 percent interest. The one-off charge of 0.9 percent (= 6 months, or one half, of the annual interest of 1.8 percent). But this cost can be spread over the remaining 3-year life of the mortgage and so equates to 0.3 percent open equation left hand side equals right hand side 0.9 postfix times percent prefix division of three close per year. That totals 2.1 percent open 1.8 percent prefix plus of 0.3 percent close of lost earnings per year against the 3.2 percent 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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Discussion

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.

MSE_1

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