Why overpaying on your mortgage is better than saving
Wednesday, 02 March 2011 11:01
by Ben Salisbury
With savings rates still very low one of the best ways of making the most of your money is to overpay your mortgage.
The basic principle
It is worth overpaying your mortgage if the amount you can save on mortgage payments is greater than the return you can make from the top paying savings accounts. When you apply this to your own scenario you need to take into account whether you are a basic rate or higher rate taxpayer because this will impact how high a return you can get from your savings.
Recent history
Historically, there have been plenty of periods when you can make more money through saving than you can save from overpaying on your mortgage but this is usually at a time when high inflation has led to high interest rates and consequently high savings rates. In the 1990’s finding a savings account that paid ten per cent was fairly easy.
When ISA’s were introduced, with their tax free status, it was reasonably argued that saving through an ISA could outweigh the benefits of overpaying on a mortgage. However, since 2008, when interest rates began to fall dramatically, and definitely since March 2009, when interest rates fell to 0.5 per cent, the level at which they have remained, overpaying on a mortgage has been the better option.
What are overpayments?
Overpayments are additional payments that you can make on your mortgage either as an extra component of your monthly repayment or on top of your monthly repayments. They may be made on a regular basis or as a one-off and will reduce the length and cost of your mortgage.
Why is overpaying on a mortgage the better option?
The amount of money that most people owe on a mortgage is higher than the amount they have in savings. Therefore the weighted effect of a change in interest rates has more impact on your money in terms of how it affects your mortgage than on how it affects your savings.
Another benefit is that by overpaying on the mortgage you reduce the balance owed on the mortgage which makes it easier to get a better deal when it is time for you to re-mortgage.
When is the time to do it?
It is always a good time to overpay on your mortgage and as mentioned before when the saving you make on overpaying outweighs the interest you can earn from saving. However, there are times to avoid using your money in this way. If the cost of your debts are high because you have a credit card debt or personal loan that is repayable at a higher rate of interest you should clear the most expensive debt first.
Mortgage interest is calculated in two ways, either daily or annually. It is better and more common if it is daily as the overpayments get to work immediately on reducing the interest you pay. It is important to check that no early repayment charges or redemption fees are liable if you make a lump sum overpayment. Read the terms and conditions of your mortgage and make lump sum overpayments when you are allowed to and are not penalised for doing so.
Coming off of a fixed rate
One of the best opportunities for overpaying on your mortgage is when you come off of a fixed rate deal and revert to the lenders standard variable rate or, even better, there discounted rate.
A lot of people have done this over the last few years and enjoyed lower repayments by finishing a fixed rate deal at perhaps five or six per cent and rather than re-mortgaging, just taking up their lenders lower rate. However, it is possible to choose to continue paying the same amount, but because you are now repaying at a lower rate of interest, in effect you are overpaying and enjoying the benefits of reducing the term of the mortgage and paying off a larger proportion of the capital.
Let’s take a look at an example:
A homeowner who has a mortgage of £90,000 over 25 years and was on a three year fixed rate deal charging interest of 5.39 per cent from July 2007 to July 2010 and making repayments of £550 per month.
In the first few years of the mortgage £400 of that £550 monthly repayment was just paying the interest, so the capital owed is only being reduced by £150 a month. This is normal at the start of a mortgage term, but as the mortgage deal draws to a close and interest rates are at 0.5 per cent, the homeowner has the opportunity of getting a deal at a better rate.
So, they accept the offer from the lender to go onto their standard variable linked discounted rate at 2.99 per cent and also pay £2,000 of their mortgage in a lump sum at a time when it incurs no penalties. This means that the monthly repayment goes down to £440 whilst that rate applies over the remaining 22 years of the mortgage.
However, if the homeowner chooses to continue to pay the same amount as when they were on a fixed rate, £550 per month, we start to see some appealing numbers. If this rate were to continue at the same level and the homeowner continued to pay £550 per month they would repay their mortgage in 15 years and nine months. This is more than six years earlier and will save the homeowner tens of thousands of pounds in interest payments.
Of course, the discounted rate from the lender won’t stay at that level and will rise as interest rates do from their historically low level of 0.5 per cent. However, the important point is how the £550 is working whilst our homeowner is overpaying. The interest element is only £210, not £400, so £340 of the £550 paid each month is reducing the capital owed.
Of course, this happens naturally over the course of a mortgage term, but by overpaying the homeowner can dramatically accelerate this trend. At the time when their discount rate deal comes to an end or rates rise, the homeowner can stop overpaying, but now there is a smaller capital balance owed on which the higher mortgage interest rate can do its evil work on.
Use the Myfinances.co.uk comparison tools to find a better mortgage.
When should you avoid overpaying?
As mentioned before you should pay off the debts that incur the highest amount of interest above overpaying on your mortgage but that aside, if you can overpay on your mortgage it helps because getting your massive mortgage debt a little cheaper can outweigh paying a higher interest rate on a smaller debt.
The credit crunch saw the end of 100 per cent LTV (Loan to value ratio) mortgages so for people who got a mortgage with little or no deposit it has been difficult to get a new deal if very little equity has been repaid. This is another advantage of overpaying on your mortgage, reducing the capital owed and lowering your LTV ratio makes it easier to get a cheaper mortgage. So, if you have savings, it is normally best to reduce your mortgage with that money.
Benefits of an emergency cash fund
It is always best to have four months money saved away for a rainy day before you overpay on your mortgage. Having a cash emergency fund is wise because if you lose your job or some large unexpected bills come up you can cover the costs without having to borrow at a high rate that would negate the advantages of overpaying on your mortgage. Remember, cash that is paid into a mortgage has gone and has been used. It cannot easily be taken out again, so a source of liquid cash is a good idea.
Investing rather than saving
It is possible to get better returns through investing rather than saving and quite possible to earn more than ten per cent a year which could outperform the benefits of overpaying on your mortgage, but you could easily lose money or make substantially less than ten per cent.
In summary: Why overpaying your mortgage is better than saving
The crux of the matter is that for most people the amount owed on a mortgage is a lot higher than the amount of savings they have. Therefore, it is not just the rate that you pay on your mortgage or the rate that you receive for your savings that is important. What is also material is the base amount that the interest rates set to work on.
The interest rate attached to a mortgage results in you paying more so it is nearly always the best bet to reduce this amount so that the money you owe becomes less. By overpaying you reduce the term of the mortgage and lower the capital owed quicker.
Use the Myfinances.co.uk comparison tools to find a better mortgage.
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