Homeowners facing a jump in mortgage repayments may be prompting some to consider diverting any spare cash towards paying down their mortgage rather than stashing it in a savings account.

In December 2021 it was possible to lock into a two-year fix at about 2.34%, but following a series of base rate increases in the past two years a bid to tame rampant inflation, the average two-year fixed rate has jumped to 5.56%, according to Moneyfactscompare.co.uk. While the Bank of England held the base rate at 5.25% at its last meeting, mortgage rates remain relatively high. This means that anyone needing to remortgage imminently could see hundreds, if not thousands of pounds added to their annual mortgage costs.

As a result, those with savings may be considering trying to reduce their mortgage balance before they remortgage, so that they can keep monthly costs to a minimum.

Here, we look at the pros and cons of overpaying your mortgage compared to saving, and how doing so could potentially save you large amounts in interest and reduce your mortgage term.

Overpaying vs savings - which should I go for?

Overpaying your mortgage is usually only worthwhile if the rate you are paying on your mortgage is greater than the rate you’re earning on savings.

Savers are benefitting from some of the highest interest rates in decades following the hikes in the Bank of England base rate, which currently stands at 5.25%. The top easy access savings rate now pays 5.25%, meaning that someone with a savings balance of £10,000 would earn £525 in interest over a year before tax.

If you used this money to overpay a 5% mortgage, though, it would reduce costs by £500 for the year. 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 three years and save the homeowner a huge £22,185 in interest over the lifetime of the mortgage.

This benefit mainly applies to mortgages that have been recently taken out and have higher rates, as if you’ve a mortgage you secured a couple of years ago, your rate is likely to be lower than this. If it is, it may be worth considering sticking to savings for the time being, particularly as rates are on the increase. You could, in this scenario, consider keeping your money in savings until your fixed-rate deal ends, and then think about using it to reduce your mortgage balance before you come to remortgage.

Although overpayments for those facing higher mortgage rates are likely to make better financial sense than saving at the moment, remember that it’s still vital to have a 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 have 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 in our guide How to build an emergency cash buffer.

How do I make mortgage overpayments?

Arranging mortgage overpayments is usually pretty straightforward. You’ll need to get in touch with your lender to let them know you want to overpay, and to check whether the terms of your particular mortgage allow you to do this.

If you manage your mortgage online, you might be able to increase your monthly mortgage payment via your online account so that you overpay each month, or you can give your lender a call to set this up.

When should I make the overpayments?

You can either make a lump sum overpayment (check the terms of your mortgage first) if you have savings readily available, or you can make regular overpayments each month.

These are usually made at the same time you make your normal monthly mortgage payments.

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 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 at a rate of 5% with 10 years left to run who makes £50 monthly overpayments would reduce their term by four months and pay £1,705 less in interest. If they upped their overpayments to £100 a month, they’d reduce their mortgage term by nine months and pay £3,273 less in interest.

3. The benefits of overpaying a mortgage

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), whereby 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 £28,480 in interest alone and cut five years and 11 months off your mortgage term, meaning you could pay off your home loan in full in less than 15 years. This example assumes the same 5% mortgage rate.

Overpaying the same size mortgage by £250 a month with only 10 years left to run would save you £7,292 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.

You can use our mortgage service to compare remortgage deals from the whole of the market and find out how much you might be able to save. If you are nervous about switching lenders, it is still worth filtering for deals from your existing lender so you can see how much you could save from remortgaging with them. Our mortgage service allows you to compare the best rates from both your current lender and the wider market, quickly and easily.

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 still relatively low, but it’s worth considering your tax position if they continue to 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, check out 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 overpaying your mortgage, it’s therefore vital to consider whether you still have enough spare funds available to cover any unexpected outgoings.

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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, but even then an offset deal won’t always end up being cheaper than a standard mortgage, especially now that savings rates are much more competitive than previously.

As a general rule, those who are likely to be best off having an offset mortgage are higher and additional rate taxpayers who earn less interest from their savings once tax is deducted, or homeowners who want to overpay but retain access to their savings.

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. You can find out more about how offset mortgages work in our guide What is an offset mortgage?

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