Overpayments are a powerful, yet often overlooked, feature of your mortgage. Making overpayments on your mortgage is one way to spend any extra disposable income you may have, but is it really the best thing to do with your money? This article explores the pros and cons of making overpayments on your mortgage and when it would be a good option for you.
What are Mortgage Overpayments?
When you take out a mortgage, the money you borrow is known as the capital. Your mortgage lender will charge interest on the capital borrowed, which increases the cost of buying your house. Unless it is an interest-only mortgage, your mortgage lender will calculate the monthly repayments you need to make to pay off the loan within the agreed term.
Mortgage overpayments refer to paying back your outstanding balance earlier than agreed, either as regular payments, a lump sum, or a combination of the two. This has the effect of paying off the loan quicker, reducing the overall interest you have to pay, and saving you money.
Why Should You Consider Overpaying Your Mortgage?
There are a number of advantages to making overpayments on your mortgage, the most obvious one being that you’ll clear your debt much quicker.
As you pay off the debt in a shorter period than agreed, there is less overall interest to pay on the loan so you save money. This means it may be worth using some of your savings to overpay your mortgage. For example, if your cash is held in a savings account at 5% interest and the rate is 6% on your mortgage then you would be paying more interest than what you’re earning from your savings pot. Unless you have a considerably low mortgage interest rate you’re likely to be losing money.
What’s more, as overpayments increase the equity you own in the property this gives you a lower, more favourable loan-to-value (LTV) ratio, which qualifies you for better deals when it comes to remortgaging. The higher this ratio is, the more of a risk you are to the lender which is why the more capital you own in the property, the better mortgage deal you can get.
For example:
If you take out a mortgage of £350,000 over 30 years at an interest rate of 5.38%, and you committed to overpaying by just £500 per month, your saving would be £147,360 in interest alone, and your mortgage would be paid off 11 years and 1 month quicker.
What Should You Keep in Mind When Overpaying Your Mortgage?
There are a few things to consider when deciding whether or not it’s a good idea to overpay your mortgage.
First of all, think about whether you can afford to use your money in this way. If you don’t have a lot of disposable income or cash savings then overpaying your mortgage could pose a risk because it could leave you with less money in an emergency.
Secondly, take an honest look at your finances and see whether you have more expensive outstanding debts to pay. Interest on products such as credit cards, store cards, and overdrafts can skyrocket making them a priority to pay off rather than a mortgage which typically has a much lower interest rate.
Another important consideration is how much your lender will allow you to overpay before imposing early redemption fees. Most lenders allow you to make an overpayment of 10% of the total outstanding mortgage balance, but you will be charged a fee if you pay too much. Be aware that making a big overpayment could end up costing you thousands of pounds if you go over the limit.
Should I Overpay my Mortgage or Reduce the Term?
Another way to pay back your mortgage quicker is to reduce the term of your mortgage. Rather than paying more money to the lender either as a regular monthly payment or lump sum on your current deal, you can arrange a new deal with higher monthly repayments. Your savings tend to be much higher with a reduced mortgage term because it eliminates a large chunk of accumulated interest.
The downside is that once you are locked into a new deal, you can’t reduce your monthly payments without remortgaging. If your financial circumstances change you may find yourself struggling to keep up with the higher monthly payments, especially if you are on a variable-rate deal and interest rates are rising.
The advantage of simply making overpayments on your current mortgage deal is that you can choose whether or not to overpay depending on your available cash. This gives you a certain degree of flexibility and reduces the financial risk that committing to regular higher monthly payments brings.
How Much Can I Overpay on my Mortgage?
There is usually a limit to how much you can overpay. When you take out a mortgage, you will be tied in for a set period during which you will be penalised if you want to remortgage or pay off the loan. The common maximum limit to how much you can overpay each year is 10% of the outstanding balance of your mortgage, however this amount will vary depending on the nature and terms of your contract. If you go over this limit you may face a large fee, which may cancel out the savings you’ve made.
Lenders charge these fees because by paying off your mortgage quicker you’re depriving them of their profit gained from the interest. Each lender will differ in its policies so it’s best to check with your provider before making any overpayment.
Should I Make a Regular or Lump Sum Mortgage Overpayment?
You can make these overpayments regularly or as a lump sum. As long as you stay within the maximum limit for that year, you won’t be penalised. Making lump sum overpayments saves you more interest overall, reduces the loan-to-value ratio quicker and helps you pay off the debt sooner. However, it’s probably more affordable for most people to make regular payments as you can budget accordingly or cancel a payment if you need to.
Also, the risk is greater when making a lump sum overpayment. Once paid, a big pile of spare cash is gone and you won’t get it back easily if you suddenly need it. You may have to remortgage the property to release equity if you discover that you require that money. That’s why it’s important to always keep an emergency pot just in case.
Balancing Mortgage Overpayments with Other Financial Goals
In general, you should only make mortgage overpayments if you can truly afford them. Make sure you have an emergency fund set up to cover unexpected expenses and that there are no other pressing debts to be paid. It’s not worth making yourself temporarily financially vulnerable just to pay off your mortgage quicker.
If you are considering overpaying your mortgage, or would like further information, Cooper Associates’ experienced and award-winning mortgage advisers can help. We offer help evaluating your mortgage options and provide personalised advice on making overpayments so you can get the most out of your money.Use our mortgage calculator to calculate the effect of any mortgage overpayments you wish to make. Get in touch today for more information.
