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Many homeowners will long for the day when they’ll finally be mortgage-free. Making mortgage overpayments is one way to try to bring that day forward, whether by paying a little extra on your monthly payments when you can or by paying off a hefty lump sum.
It might seem a reasonable step to take, but with savings rates now finally paying some meaningful returns, many mortgage borrowers with cash to spare will be facing a dilemma: is it better to pay off my mortgage or should I put the money into a top-paying savings account instead?
“Overpaying your mortgage reduces the debt you owe and the interest you pay over the term of the loan,” explains Mark Harris, chief executive of mortgage broker SPF Private Clients. “If you have savings earning very little in the way of interest and your mortgage rate is higher, it makes sense to use your savings to reduce the interest on the mortgage.”
Do you already have savings or other debt?
Before rushing off to check the interest rate on your mortgage and how it might compare to top savings rates, give some thought to other aspects of your financial situation.
“It is important to remember that money overpaid is virtually impossible to get hold of again, so you should keep funds back for a rainy day rather than putting everything into the mortgage,” says Harris.
The usual recommendation is to have enough savings set aside as an emergency fund to cover at least three months of your typical living expenses, and perhaps even six. The money should also be easy to access, in case you need it quickly. But even when you’ve set up your rainy day fund, paying more off your mortgage might not be the right option for your individual circumstances.
“It is not the best idea to overpay on your mortgage if you have an outstanding debt on a credit card or overdraft,” Harris adds. “You are likely to be paying a significantly higher rate of interest on the latter while the mortgage rate is comparatively lower. Therefore, it makes sense to pay off the expensive debt first before turning your attention to cheaper debt.”
What are the rules around overpaying?
If you have sufficient savings set aside and your priority debts are in hand, you could be in a position where you’re able to pay more off your mortgage. The next step is to contact your mortgage provider to check whether there are any penalties for overpaying, as these could potentially undo some of the benefit you stand to gain from paying extra.
“Most lenders let you overpay up to 10% of the outstanding mortgage amount per annum without penalty, which is enough for most people,” says Harris. “There is little point paying more if you are going to be penalised for doing so.”
Have you done the maths?
Trying to work out if it would be better to overpay your mortgage or put the funds into savings is then the key. Spending time playing around with a mortgage overpayment calculator to see what difference the extra money you can put into your mortgage will make might help inform your decision. At the same time, using a savings interest calculator will give you an idea of the return you would get by putting the money into savings.
As a general rule of thumb, if your mortgage rate is higher than the best savings rate you can get, a strong argument can be made that you should reduce your mortgage rather than keep your money in cash.
“Overpaying the mortgage is generally a good idea inasmuch as the interest on deposit accounts tends to be 2% below the mortgage base rate, therefore the rate of return achieved by repaying the loan is higher than when depositing in a savings account,” says Alan Lakey, director at Highclere Financial Services Ltd. He adds that people often derive psychological benefits from seeing their mortgage balance decrease more rapidly too.
However, if the situation is reversed, and you’re on a low, fixed-rate mortgage while higher savings rates are available, you might be better off putting the money in a savings account to make the most of the higher returns. “At a later date, when the mortgage rate increases, the funds can be used to make a lump sum overpayment,” suggests Lakey.
Could your mortgage type make a difference?
Given interest rates on savings have been so low over the past few years, Harris says it has generally made sense to pay more off your mortgage if you could. Now, however, things might be changing.
“With savings rates slowly rising, this may be less true,” he says. “It may also be worth looking at an offset mortgage where you can offset savings against your home loan to reduce the interest you pay but also retain access to your cash in case of an emergency, giving you the best of both worlds.”
In a similar vein, the type of mortgage you have is another factor to consider if you’re conflicted over whether to save or pay more off your mortgage.
“If you have a repayment mortgage, it will be paid off by a certain date anyway, so overpaying may be a luxury rather than a necessity,” Harris points out. “However, if you have some or all of the mortgage on an interest-only basis, then you need to consider your strategy for paying back the balance by the end of the term. Overpaying is a useful way of doing this.”
What about other financial priorities?
Depending on your situation, it’s also important to consider other ways the funds you’ve earmarked for saving or overpaying could be used. For example, making sure you have adequate financial protection for you and your loved ones, and putting money into a pension.
“Protecting the family against the financial repercussions of ill health and premature death is priority number one,” says Lakey. “Once this has been put in place, a retirement strategy can be arranged.”
To make sure you’re seeing the bigger picture, Harris says it’s important to seek independent financial advice, particularly when it comes to retirement planning.
“With a pension, the longer you pay into it the better so if you can keep this going alongside overpaying on your mortgage, this may be a sensible strategy,” he suggests. “However, with the rising cost of living, it may be the case that you only have enough resources to do one or the other, so you need to make a choice and should seek advice.”
Note: The content of this article does not constitute advice, but as guidance and commentary on the savings and mortgage market.
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