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. 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 rates 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, it is essential to look at your overall finances, 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:
- 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 significant high-interest debt with, for example, a credit card or personal loan, the monthly interest charge will be significantly higher than a traditional mortgage. As we touched on above, 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. There is still the option of making payments to both your high-interest debts and mortgage if you have sufficient additional capital available.
How does overpaying on your mortgage work?
Due to regulatory pressure, the vast majority of 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 take a 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 straight forward. Each overpayment will reduce the capital element, and therefore reduce 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 as opposed to £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. As a consequence, each additional mortgage overpayment will reduce the capital remaining, which will reduce 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. 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 your mortgage would be repaid 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 more of the monthly element will be skewed 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 that you can make additional overpayments at your discretion.
Reduced mortgage term
When formally reducing the term of your mortgage, you will likely need to go remortgage, which may well incur costs. If you have seen a reduction in your regular income, say you are fully or semi-retired, you may struggle with the remortgage affordability test. The idea would be to incorporate previous regular payments with overpayments. This would place things on a more formal setting, taking away the previous discretionary element of your mortgage repayment.
Does mortgage overpayment reduce monthly payment?
When looking at an interest-only mortgage, any overpayments would go towards reducing the end of term capital repayment. This would therefore reduce your interest charge each month. 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 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 of career progression, and salary, traditionally peak during this period of your life. Even though there is a growing trend towards extended employment years, this could be on reduced income or even part-time hours.
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 be very different.