The subject of mortgage overpayments is very topical, especially in the current low-interest-rate environment. Historically, with mortgage rates often above 5%, the situation was a little clearer. However, in more recent times, credit card interest rates, as one example, have not followed the trend of mortgage rates. This has resulted in a more significant difference between mortgage and credit card rates, prompting many homeowners to look in-depth at their options.
Is overpaying your mortgage worth it?
While starting to make mortgage overpayments in your 30s would have been ideal, there's nothing wrong with starting later in life. The proverbial "finishing line" of your final mortgage payment might already be on the horizon by now, which might act as motivation for you to make those extra payments. If you are considering making mortgage overpayments, looking at your overall finances is essential to see where any additional funds could be better used.
A recent from The Money Charity from March 2020 casts a fascinating light on debt in the UK. The report confirms that:
- 12.8 million households in the UK have either no savings or less than £1,500.
- Average debt per UK household was £60,363.
- Unsecured debt per UK adult averaged £4,264.
- Average credit card debt per household was £2,595.
- Outstanding credit card balances fell by just 0.3% throughout 2019.
- Average credit card interest was 20.77%.
- It would take 26 years and eight months to repay the average credit card debt (minimum payments).
This report perfectly addresses the need to consider high-interest debt together with long-term mortgage overpayments.
Should you address high-interest debt before mortgage overpayments?
If you have high-interest debt like a credit card, the monthly interest charge will be significantly higher than a traditional mortgage. Earlier this year, the average credit card interest rate was 20.77%, against circa 4% for standard variable rate mortgages.
Even though UK base rates are currently at historic lows, you could be paying double-digit interest rates on:
- Personal loans.
- Credit cards.
Therefore, it is no surprise many people are looking to repay high-interest debt first. However, you can still make additional payments to your high-interest debts and mortgage if you have sufficient capital available.
How does overpaying on your mortgage work?
Due to regulatory pressure, most relatively new mortgages in the UK are repayment, as opposed to interest only. This means that each monthly payment will consist of an element of capital repayment and interest charged. We will now look at the impact of mortgage overpayments on each type of mortgage.
Overpayments on an interest-only mortgage
As you only pay interest each month, with the capital repaid at the end of the term, mortgage overpayments on interest-only mortgages are straightforward. Each overpayment will reduce the capital element and the interest charged each month. Unless you specifically request otherwise, the mortgage term would remain unchanged. However, monthly interest payments would continue to fall with regular overpayments.
Example of the impact of interest-only mortgage overpayments:-
Term: 25 years
Mortgage interest rate: 3%
Result: In this scenario, you would reduce your interest charge by £14,601 and your mortgage capital by £44,601. So, at the end of your mortgage, you would have £55,399 to repay instead of £100,000.
Overpayments on a repayment mortgage
The situation with a repayment mortgage is slightly different. Unless you specifically ask your mortgage provider to recalculate your monthly payments, they will likely remain unchanged. Consequently, each additional mortgage overpayment will reduce the capital remaining, reducing the interest charged. As the interest charge falls, the capital repayment element of your monthly repayment will increase. This is the natural process with repayment mortgages, but with overpayments, the process is more pronounced. As a result, the capital repayment element increases much quicker.
Example of the impact of repayment mortgage overpayments:-
Term: 25 years
Mortgage interest rate: 3%
Result: In this scenario, you would save £10,286 in interest charges and repay your mortgage five years and ten months earlier than your original term.
Is it better to overpay your mortgage or reduce the term?
This is a question faced by many people. Should you continue with regular overpayments or remortgage on a reduced term? Some of the factors to consider include:
Mortgage overpayments will naturally reduce the term of a repayment mortgage, as they will skew more of the monthly element towards capital repayment. The situation is different with an interest-only mortgage, as the term will remain constant with the interest charge reduced as the capital is repaid. Keeping the overpayments arrangement "informal" means you can make additional payments at your discretion.
Reduced mortgage term
When formally reducing the term of your mortgage, you will likely need to remortgage, which may incur costs. The idea would be to incorporate previous regular payments with overpayments. This would place things on a more formal sitting, removing the discretionary element of your mortgage overpayments.
Does making mortgage overpayments reduce my monthly payments?
If you have an interest-only mortgage, overpayments will reduce the end-of-term capital repayment. This would therefore reduce your interest charge each month. However, it is worth confirming with your mortgage provider how and when they calculate mortgage interest because this could impact your payment timing.
The situation is different when it comes to repayment mortgages. You may find there is a minimum repayment threshold, after which your mortgage provider will automatically recalculate your monthly repayments. Before this calculation, your monthly repayments will remain constant, but a more significant element would go towards capital repayment.
Should you use pension income to fund mortgage overpayments?
Under current personal pension regulations, you may be entitled to start withdrawing funds from your pension plan from age 55. It will depend upon your financial situation at the time, but this may allow you to make regular or one-off mortgage overpayments. In recent times we have seen the maximum age for mortgage eligibility increase. So if you took out a mortgage in your 50s, you could still have upwards of 20 years of repayments remaining. The long-term savings from mortgage overpayments are relative to the term left on your mortgage - not necessarily your age.
There seems to be a belief that mortgage overpayments make a more significant difference in your 30s and 40s. This is simply because career progression and salary traditionally peak during this period of your life. So even though there is a growing trend toward extended employment years, this could be on reduced income or even part-time hours.
"Clarifying your financial goals is a good place to start before considering whether to pay down your mortgage and by how much," says Alex Whitson, Managing Director of VouchedFor.co.uk, the financial adviser ratings site.
“If your plan is to retire at 65 with an annual income of £20,000 for the rest of your life, it may be better to increase your pension contribution instead.
"A financial planner can help provide clarity here, by producing a cashflow forecast. They can show you the impact of reducing your mortgage debt vs increasing your pension contribution. They can also model external factors, like interest rate rises or stock-market crashes.
"Clarifying long-term goals helps to avoid knee-jerk reactions to economic news.
"It’s important to note that everyone's situation and attitude towards money is different. For instance, some people are more comfortable with mortgage debt than others. This is a key consideration in arriving at the best decision for you and your loved ones."
Should you make mortgage overpayments?
While the idea of making mortgage overpayments can be attractive, this needs to be balanced with the issue of high-interest debt. This can include personal loans, credit cards and bank overdrafts - often attracting double-digit interest rates. Compared to standard mortgage rates (currently around 4%) and discounted offers (sub 2% in some cases), there is an argument for addressing high-interest debt before mortgage overpayments. You will also find some mortgage companies charge an early repayment fee if you make annual overpayments above 10% of mortgage capital outstanding.
It is vital to consider mortgage overpayments in the context of your broader financial situation. Looking at individual issues in isolation can often create a narrow picture when the bigger picture may differ.