If you’re in a position to overpay your mortgage, there can be significant benefits. Not only will you pay off your mortgage loan sooner but you’ll reduce the overall amount of interest you have to pay. But how does overpaying your mortgage compare with saving your money? Would it be better to reduce your mortgage term instead? Here, we’ll explain how overpayments work with the pros, cons and considerations to help you make the right decision.
What is a mortgage overpayment?
A mortgage overpayment is an additional payment to the regular monthly mortgage payments you make. Any overpayments you make reduce the balance of your loan faster, taking you another step closer to being mortgage-free. As you’re reducing the balance, you’re also cutting the amount of interest that’s charged. This can save you a considerable sum over the term of your mortgage. You can make regular overpayments or a one-off lump sum to suit your circumstances.
The benefits of overpaying your mortgage
Your monthly mortgage payments are based on the amount you’ve borrowed, the interest rate you’re paying and the mortgage term, such as 25 years. By making overpayments on your mortgage, there are several benefits:
- Shorten the mortgage term. As you are paying off more of your mortgage balance each time you make an overpayment, you’re reducing the time it will take to repay your mortgage in full. This brings you closer to being debt-free and owning your home outright.
- Reduce your interest payments. Interest is calculated on your mortgage balance so by making overpayments, you reduce the amount that interest is charged on. This can result in lower monthly payments.
- Pay less interest over the life of the loan. As you only pay interest on the balance owed, reducing it with overpayments can save you a significant amount of interest charged over the mortgage term.
- Secure better rates if you remortgage. Reducing your mortgage balance with overpayments increases the equity in your property. This lowers your loan-to-value (LTV) ratio. Having a lower LTV may enable you to get a better deal with a more competitive interest rate if you remortgage.
- Have potentially higher savings than with a savings account. You may save more with the savings you make in reduced interest payments on your mortgage than with the interest earned in a savings account.
The drawbacks of overpaying your mortgage
There are a few drawbacks to consider before using your spare cash to make mortgage overpayments:
- You may incur a fee. Most lenders allow you to make an overpayment of a certain amount each year, such as 10% of the balance. If overpayments aren’t possible with your mortgage deal or you want to pay more than the allowance, you’ll be penalised with an early repayment charge (ERC). An ERC can be very costly, often ranging from 1% to 5% of the outstanding loan balance.
- You’ll have less cash in hand. Money used to make overpayments can’t be claimed back from the lender, even in an emergency, unless you have a flexible mortgage. Therefore, make sure you have a safety net first in case you have any unexpected expenses or your financial situation changes.
- Other debts may be costing you more. If you have other debts, such as outstanding credit card balances, it may be better to pay them off first. The interest rate for your mortgage is likely to be lower than the rates for your other debts and, as such, they’ll be costing you more.
How to make overpayments
There are a few options to consider when making overpayments. The one you choose will depend on your financial circumstances and your lender’s preferences. These options include:
- Regular overpayments. You can increase your normal monthly payments by a set amount. This may be a good idea if you’ve had a pay rise at work, for example.
- Overpaying with a one-off lump sum. You may have received a bonus at work or an inheritance, for example, and want to use it to pay a lump sum off your mortgage.
- Using a combination of these methods. You can combine both of these methods by making increased mortgage payments each month and paying a lump sum when you’re able to.
There are various ways to make overpayments so check with your lender to find out what they prefer. Usually, you can overpay online or by phone while other methods can include bank transfers, setting up a standing order, visiting the branch or using a mobile banking app.
Lenders usually offer two options when making overpayments. You can:
- Reduce the next month’s payment by the amount that you’ve overpaid
- Keep your payments the same and shorten the term of your mortgage
It’s best to reduce your mortgage term as you’ll save a lot more in interest that way.
Considerations before you overpay your mortgage
Check that the terms of your mortgage deal allow you to make overpayments and, if so, by how much. If overpayments aren’t allowed or you wish to exceed the allowance, you may be penalised with an ERC. Find out how much this fee will cost and then compare it with the savings you stand to make by overpaying your mortgage to see if it is worth it.
Before making an overpayment, check the interest rates for any other debts you’re paying off. They’re likely to be higher than your mortgage interest rate, in which case it’s better to put your extra cash towards clearing these debts first.
Rather than making overpayments, it may be more beneficial to adjust your mortgage term. Shortening the length of the term will increase your monthly payments but you’ll repay your loan quicker.
Check the interest levels on savings accounts, look at long-term investments and find out what impact there would be by investing in your pension pot. Compare these options with overpaying your mortgage to find out which route is the most beneficial to you.
Is it better to overpay or shorten your mortgage term?
Whilst overpaying reduces your mortgage term as you’re repaying the outstanding balance faster, this is different from changing your mortgage to reduce its term.
With the latter option, your mortgage term is officially reduced, which increases your monthly payments. You are then liable to make those higher payments throughout the remaining term. If you’re in a financial position to do this, it’s worthwhile. You’ll reduce the amount of interest that’s payable overall and you’ll be mortgage-free sooner.
However, you need to consider what will happen if something unexpected happens in the future. If you have a variable rate mortgage and the rate goes up, will you still be able to afford the monthly payments? If your income suddenly drops, how will you cover the higher payments?
Overpaying, however, offers more flexibility than reducing the term. It has the same results – reducing your balance faster and cutting down the overall interest costs – without tying you into a permanent arrangement. You can make overpayments when you’re in a financial position to do so and simply continue with your normal monthly payments at other times. That way, you’re reducing the risk of struggling if your financial circumstances change in the future.
Should you save instead of overpaying your mortgage?
If you haven’t already, you should save some money as an emergency fund before overpaying your mortgage. Things can and do go wrong so having financial backup to hand will give you peace of mind. Once you’ve used your funds as an overpayment, you won’t be able to get them back.
You should also save to clear other debts first. Usually, household debts, such as credit card balances, have higher interest rates than mortgage rates. As such, you should clear these debts first before overpaying your mortgage. Also, consider any large expenses you may need to save for in the future. For example, paying for a wedding, your children’s university fees, a big holiday or some home improvements.
When you’re ready to choose between saving and overpaying, compare your mortgage interest rate with the returns offered on savings accounts. If you can find a savings account with a high interest rate and your mortgage has a low rate, then it can make sense to save your money instead of using it to overpay your mortgage. However, if it’s more important to you to be mortgage-free sooner, then overpaying is the better choice.
Get expert advice on mortgage overpayments
Our mortgage brokers are here to ensure that you make the best decision for your needs. They’ll discuss your circumstances and explain how overpayments work, advising you on any alternatives that you might not have considered. Give us a call on 01322 907 000 for impartial advice that allows you to weigh up your options and meet your financial goals accordingly.