Rock bottom interest rates may be prompting some of us to consider diverting any spare cash towards paying down our mortgage rather than stashing it in a savings account.
As at 1 November 2020, the average easy access savings rate stood at just 0.22%, according to financial website Moneyfacts.co.uk, meaning that someone with a savings balance of £10,000 would earn just £22 in interest over a year.
If, however, the same £10,000 of savings was used to overpay a mortgage with an interest rate of 2.5%, it would save over £250 of interest in your first year, more than 10 times the amount it would earn in the average easy access savings account.
In this same example, let’s say the mortgage balance was £150,000 with 10 years left to run, by overpaying £10,000 of the mortgage now and continuing to make the same monthly payments as before, this would reduce the mortgage term by eight months and save the homeowner a huge £2,705 in interest over the lifetime of the mortgage.
Although it might seem tempting to use your savings to pay down your mortgage, bear in mind that it’s vital to have a savings cash buffer available at all times in case your income falls or you need to cover any unexpected expenses. Unlike when money is held in a savings account, if you make a mortgage overpayment it can be very difficult to get access to that money again – so it’s important to ensure that you are left with enough readily available savings should you need them. Experts usually recommend having between three and six months worth of income held as savings in an easy access account so that you can get your hands on it quickly should you need it. Find out more about building an emergency cash buffer here.
If you are considering overpaying your mortgage, here are some of the things you need to consider.
1. Check how much you can overpay
Before you make any mortgage overpayments, check with your lender to see how much you can overpay each year without incurring any early repayment penalties. As a general rule, you’re usually allowed to overpay up to 10% of your mortgage balance penalty-free each year, but always check your mortgage small-print as this can vary. This means that if, for example, you have a £150,000 repayment mortgage, you should be able to repay up to £15,000 r without facing any early repayment charges. This amount would reduce in subsequent years, to reflect 10% of your reduced mortgage balance – so always check with your lender first.
2. You don’t have to make big lump sum overpayments
If you don’t have a big chunk of savings available, that doesn’t matter, as you can usually make small monthly overpayments if you want to. For example, someone with the same £150,000 mortgage with 10 years left to run who makes £50 monthly overpayments would reduce their term by four months and pay £783 less in interest. If they upped their overpayments to £100 a month, they’d reduce their mortgage term by eight months and pay £1,505 less in interest.
3. The longer your mortgage term, the bigger the benefits
The longer your mortgage has to run, the bigger the benefits of overpaying your mortgage are. This is due to a process known as compounding (which Einstein famously declared the 8th wonder of the world), the interest you owe rolls up over time and you start owing interest on previous interest owed, which can build up significantly the longer your mortgage lasts. For example, overpaying a £150,000 mortgage with a 20 year term by £250 a month would save you an eye-watering £12,351 in interest alone and cut five years and nine months off your mortgage term, meaning you could pay off your home loan in full in less than 15 years.
Overpaying the same size mortgage by £250 a month with only 10 years left to run would save you £3,372 in interest and reduce your mortgage term by one year and eight months.
4. Reducing your mortgage debt might boost your remortgage options
If you overpay your mortgage over the years, you might find you’re eligible for better remortgage deals, as the best mortgage rates are normally reserved for those with a large amount of equity in their homes.
This is because homeowners borrowing smaller amounts in relation to their property value are considered the lowest risk by lenders. If you’ve been overpaying your mortgage and benefiting from rising house prices over the years, you are more likely to own a greater proportion of equity in your home.
5. Think about tax
Overpaying your mortgage has the benefit that you don’t pay tax on your mortgage interest savings.
If you keep lots of cash in a savings account and have used up your personal savings allowance (which means basic rate taxpayers don’t have to pay any tax on savings interest up to £1,000) or if you’re a higher-rate or additional taxpayer and are entitled to a reduced £500 or no PSA respectively, you may have to pay tax on some of your savings interest.
The vast majority of people don’t pay tax on the savings interest they earn, as savings rates are currently so low, but it’s worth considering your tax position if they rise in future.
6. Look at your other financial commitments
Before you overpay your mortgage, you’ll need to take your other financial commitments into consideration. For example, do you have any other more expensive debts, such as personal loans or credit cards, which you should focus on paying off first? Or could paying down your mortgage early prevent you from saving for retirement?
If so, then paying off your mortgage early might not be the right option for you. Seek professional advice if you need help working out your financial priorities. You can find a local financial advisor on VouchedFor or Unbiased, or for more information, read our guide on How to find the right financial advisor for you.
7. You can’t usually get your savings back again
Although making mortgage overpayments can have lots of financial advantages, there are some significant downsides you need to consider too.
The most important thing to remember is that once you’ve made overpayments, you can’t usually get this money back. That means if you suddenly have a big expense to cover, such as needing a new boiler for example, you might have to use all your emergency savings to pay for this, and because your other spare cash has gone towards your mortgage, you won’t then have a cash buffer in place. Worse still would be if you ended up having to take on expensive additional borrowing, to pay for any nasty financial surprises.
If you are considering making overpayments, it’s therefore vital to consider whether you still have enough spare funds available to cover any unexpected outgoings.
8. An offset mortgage may be worth considering if you still want access to your savings
If you have a large amount of savings and you’re keen to clear your mortgage as soon as possible, but still want to retain access to your savings, you might want to think about an offset mortgage rather than overpaying your mortgage..
With this type of mortgage, as the name suggests, your savings balance is set against the amount you owe on your mortgage, and you hold both your savings and your mortgage with the same provider. You only pay interest on the amount that’s left.
For example, if you have a £150,000 mortgage and £50,000 in savings which you offset, you’d only pay interest on £100,000 of your mortgage.
The main benefit of an offset mortgage over simply making overpayments is that you can withdraw your savings at any point if you need to. Bear in mind though that offset mortgages tend to have slightly higher interest rates than standard mortgages, so they are usually only suitable for those with a significant amount of savings. According to the Homeowners Alliance, borrowers should ideally have enough savings to cover at least 20-25% of their mortgage to make an offset mortgage worthwhile.
For example, if you have a standard £150,000 mortgage over 10 years at a best buy two-year fixed rate of 1.32%, your monthly mortgage payments would be £1,335 and you’d pay £3,602 in interest over the two-year fixed rate term. If you also have £50,000 in savings and put this into an easy access account paying 0.22%, you’d earn £220 on your savings over the two year period. In total this means the net interest cost to you (the total amount interest you’d pay once your savings interest has been factored in) would be £3,387 over the two years with a standard mortgage.
If, however, you’d gone for a best buy offset mortgage over a comparable two-year fixed rate at 1.69%, you wouldn’t earn any interest on your £50,000 savings, but offsetting this amount would mean you’d only pay £2,896 in mortgage interest over the two years. In total, you’d save £491 in interest over the two year fixed rate period by going for an offset mortgage rather than a standard deal.
It’s not always easy to work out whether an offset mortgage is the right option for you, or whether you might be better off making smaller regular overpayments instead, so if you’re in any doubt, seek professional mortgage advice. Two well respected fee-free mortgage brokers you could try are Fluent Mortgages or London & Country Mortgages. They can research the various options that may be available to you on your behalf and advise on which deals may be best for you based on your individual circumstances.
Are you overpaying your mortgage or are you considering doing so? If you have overpaid, how much did you manage to save? We’d be interested in hearing from you. You can join the conversation on the Rest Less community or leave a comment below.