Should I Make Overpayments On My Mortgage To Save Money?

Almost everyone wants to pay off their mortgage as soon as possible. I am often asked if making overpayments on my mortgage will save money in the long run. This post aims to cover some of the key benefits and drawbacks, along with potential alternatives to the standard overpayment feature.

Today we will cover:

What are overpayments?

Overpayments are simply categorised as an extra contribution made to reduce a mortgage balance above and beyond the regular monthly payment. The amount overpaid is deducted directly from the balance without incurring any interest. This means that you are effectively repaying your mortgage a little earlier with each overpayment made.

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What are the key benefits of making overpayments on my mortgage?

Lets begin with the two main benefits of making overpayments are; reducing the amount of interest you pay in the long run, and repaying your mortgage earlier than expected.

First assume your regular monthly mortgage repayment is £500. Your balance is £50,000 and the interest rate is 3.74%. There are 10 years to go until the mortgage is repaid. Each £500 monthly repayment is split into two portions. One being the interest charged on the loan balance. The other will be reducing the balance incrementally until you have nothing left to pay in 10 years time.

Next assume that you make an overpayment of an additional £6,000 reducing your balance to £44,000. The first benefit is that you will not be paying interest on the £6,000 sum over the remaining 10 years. Secondly your balance will hit zero before the 10 years are up because you will owe less when the balance is recalculated. Therefore, you will actually save £2,500 in interest over the remaining term, and repay the mortgage 1 year and 4 months early. Win / Win.

Finally, overpaying when mortgage interest rates are high offers larger benefits than when they are lower. Of course when mortgage interest rates are higher, the monthly repayments will be higher also. So there may not be as much disposable income available for overpayments.

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Who is able to make mortgage overpayments?

Nearly all mortgage lenders will allow you to pay a little extra as an overpayment if you wish. In most cases there will be no financial penalty to do so. Instead there could be a limit on how much you are able to overpay without incurring any fees. However, some lenders offer mortgage products with overpayments prohibited. Or where a charge is payable no matter the amount. Always check your formal mortgage offer, or the product illustration (ESIS) for details of the overpayment facility provided. This will also let you know if there are any financial penalties for repaying some/all of the mortgage early.

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How much can I overpay and how often?

Some people like to make smaller overpayments on a regular basis. Others may prefer a larger and less frequent lump sum approach. Both work well and you will be free to choose the option that works best for you. You can also combine a mixture of the two. A lump sum reduction generally outperforms a smaller regular overpayment over the term. This assumes that the total amount overpaid is the same.

Overpayment allowances.

Many lenders have a penalty free overpayment limit of up to 10% (of the mortgage balance) each year. Anything above and beyond this amount will incur a penalty so be sure to check what your product limitations are. Usually the 10% allowance will reset each year so you can split larger amounts over 2 or more allowances. You may see products offering more or less than the the normal 10% penalty free but these are less common. 10% of the balance each year appears to be suitable for most borrowers.

Be sure to check whether the % allowance relates to the year start balance or the original loan amount. Also check when the year end period is. Some lenders use a calendar year where others use the date when the mortgage started with them

You may also find some lenders have a minimum overpayment in place. This means that smaller overpayments of less than £500 may not be accepted. In these cases simply save the funds in a savings account elsewhere until you have enough to satisfy the lenders requirement.

There are also some products available with unlimited penalty free overpayments. This means that in theory you can pay any amount at any time and not incur a charge. Flexibility such as this is great if your intention is to use it. If not there may be other drawbacks to weigh up such as a higher rate of interest, or a variable rate instead of a fixed version.

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What are some of the drawbacks when making overpayments on my mortgage?

The simple overpayment model mentioned above only takes into account the saving of time and interest relating to the mortgage. However, instead of using a lump sum to reduce your mortgage balance, you could of course invest it elsewhere using a savings account, bond or similar. Especially if you receive a higher rate of interest on your savings than you are paying on your mortgage balance.

A good overpayment calculator should take into account the interest rate you could receive elsewhere on savings. This will then give you a fuller picture of whether a mortgage overpayment will actually save you money.

Also once an overpayment has been made to reduce the balance of a mortgage, borrowing the funds back again can prove tricky. You may find that a lender will re-assess your entire financial position when requesting any additional borrowing. This is because additional borrowing is treated almost as a new application instead of just asking to “borrow back” some of the invested money. Funds being raised against the property to recoup previously invested overpayments will be likely be subject to a new mortgage rate from the lenders range at the time. Plus, there may be product or valuation related fees payable. Of course it is ultimately at the lenders discretion whether an application will be agreed or not.

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So should I be making overpayments on my mortgage?

The answer to this is yes but with caveats.

Saving interest and reducing the term of your mortgage is always going to be a good idea. In this respect making overpayments makes perfect sense. There are a few considerations to take into account before contacting your lender to overpay. Ask yourself these important questions to before committing to an overpayment on your mortgage:

• Can I afford to pay extra overpayments on my mortgage? – Inflation and the cost of living crisis won’t be going away overnight. Overpaying your mortgage has a long term end game. Take stock of your monthly disposable income and be sure that you are able to afford the extra outgoing.
  
  
• Are you comfortable that overpayments are committed after payment? – They will be difficult to recoup from the lender if needed in an emergency. Therefore, do not rely on borrowing them back again in the future as this wont always be possible. For example, if you experience a drop in salary your income may no longer support the size of mortgage you need to draw additional funds on the mortgage.
  
  
• Can I get a comparable or better rate of interest by investing the money in savings? – If your savings rate is on par or higher than your mortgage product rate you may be better off saving the money instead of overpaying.
  
  
• Are you planning a house move in the near future? – Overpaying on a mortgage offers longer term benefits. Moving house in the near future and possibly refinancing at that point may negate most of the benefits you were hoping for. Especially if the likelihood is that you will be increasing your mortgage when you move.

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Tips for making overpayments.

• When looking to overpay with regular monthly amounts, look at saving them into an ISA, or savings account first instead of paying them directly to the mortgage lender. Not only will this earn a little interest whilst in savings, you will also retain quick access to the funds in an emergency. Once you have an amount saved this can be overpaid as a lump sum.

• Avoid any charges by checking your overpayment allowances with the lender. If you have a large sum available to use for an overpayment, use the maximum penalty free allowance in the current year and save any residual amount in a separate savings account until a fresh allowance is available next year.

• If the interest rate available on a savings account is higher than the mortgage rate, consider using the savings account instead. Keep in mind that overpayments are most effective over the long term. Restraint is needed to leave saved funds untouched for a long period.

• Check with your lender to see when the balance will be recalculated after an overpayment has been made. Many lenders will amend your balance and recalculate the interest on the following day. This is ideal as the overpayment will have an almost immediate positive impact. Others will apply the changes at the end of the current month which is also acceptable. However, some mortgage lenders recalculate interest on an annual basis. This means that the overpayment effects wont be seen for some time. In these cases overpay as close to the end of the current year period as possible.

• Some lenders allow you to choose how overpayment benefits are applied. The most common benefit will be reducing the term of the mortgage. However, some will allow the mortgage term to remain unchanged and instead alter the monthly payment. Payment reductions are more commonly requested when a larger lump sum is used to reduce the remaining balance.

• Overpayments made on an interest only mortgage directly reduce the balance owed. They do not affect the remaining term. Instead the monthly repayment is adjusted to reflect interest being charged on a lower balance.

• Hedge your bets. A combination of lump sum and regular smaller overpayments is possible if you aren’t ready to commit everything. Likewise, splitting surplus funds between savings accounts and mortgage overpayments offers a great way to save money and retain some flexibility.

Alternatives to making overpayments on my mortgage.

There are a handful of offset mortgages on the market which can be useful for those with a large amount of savings. I have compiled a post specifically for offset mortgages as they can be fairly complex, However they are very handy when it comes to flexible ways in which to make your savings help pay off your mortgage.

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Post compiled by Grant Carpenter CeMAP, CeFA – 15 years of regulated mortgage advice.

Please note that the content listed within this remortgage guide is purely for information purposes only and does not constitute advice.