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There's a double whammy hitting the UK's home-owning savers. Money in the bank earns pitiful rates, while mortgage costs haven't tumbled nearly as much. So the question on many lips is: 'Should I overpay my mortgage with spare cash?'
But there are spanners in the works, including repayment penalties, how you keep emergency funds, and more. This guide will help you decide, and includes an 'is it worth it?' tool and along with a mortgage overpayment calculator.
Before you start, check:
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Important checks before you start
Before you begin, you need to establish a few key facts. Without them, you can't make this substantial financial decision.
Are your savings rates as high as possible?
This isn't a question of whether repaying your mortgage beats your current savings. Instead, it must be 'does repaying my mortgage beat the highest paying savings available?'.
Many people are earning pitiful rates, and assume they can't improve them. Yet much better deals are often available. So if you haven't already, check the Top Savings Accounts and Top Cash ISA guides for all the best rates.
You needn't switch to them right now, as overpaying your mortgage may win out. But at least know what's on offer, and compare against that to calculate the right option.
Would you face overpayment penalties?
Some lenders punish those who try to repay their mortgage quicker than agreed. This is especially common if you have a special offer fixed or discount rate deal (see the free Remortgage Guide for details).
This is because lenders want you to stick with them once the cheap rate ends, as at that point their rates shoot up. This means it's not in their interest to let you repay the mortgage more quickly, because the longer it takes you to repay, the more they earn.
Thankfully many allow up to 10% annual overpayments without penalties. But you must check with your lender, as any substantive extra costs are likely to outweigh the gains from overpaying the mortgage.
Do you have other debts, such as credit cards or loans?
A crucial rule of debt repayments is: clear the most expensive debts first. Do so and the interest doesn't build up as quickly, saving you cash and giving you more chance of clearing debts earlier. Therefore, as a rule of thumb...
Clear credit cards and loans before overpaying your mortgage, as they're usually more expensive.
Yet as with any rule of thumb, there are exceptions. Click all of the following that apply...
You're looking to get a remortgage deal
Having a smaller mortgage can mean you get a cheaper mortgage deal. The key metric for lenders is the LTV - the lower, the better.
Therefore if you've got a sizeable savings pot, by using it to reduce your mortgage borrowing and significantly cut your LTV, you may get access to cheaper rates.
Mathematically, this may be even more lucrative than paying off expensive loan and credit card debts, because getting your massive mortgage debt a little cheaper can outweigh continuing to pay a higher interest rate on a smaller debt.
However, psychologically, many people prefer to be 'debt-free', excluding their mortgage.
In truth this is a pretty rare scenario, only likely if you are close to one of the key trigger LTV thresholds - where acceptability increases substantially and cost drops - or if you have massive savings. As a rough rule of thumb these thresholds are:
90% LTV: Above this getting any remortgage can be tough, though things are loosening.
80%, 75%, 60% LTVs: Go below each of these and top mortgage deals get cheaper.
If you are at these thresholds, you'll need to do some careful numbers. If the maths is close, it's better to clear cards and loans first.
You have outstanding student loans
This specifically refers to the official loan from the Student Loans Company.
For students who started university or college in 2011 or before, interest is set at the lower of base rate +1% or the rate of inflation (RPI), making it the cheapest possible long term debt. It's possible, if inflation is high and interest rates are low, that you may have a mortgage that is cheaper than the student loan - but over the long term, that's unlikely.
Plus, unless you are earning over a set threshold (the exact amount depends on whether you started before or after 1998) you won't have to make monthly loan repayments anyway. Due to this, it's the one core type of loan you should overpay your mortgage ahead of.
For more information see Student Loans: Should I Pay them off?.
NB: Some students starting university in 2012 will pay interest above the rate of inflation, which could change this equation - see the Student Loans 2012 guide. As no one must start repaying that until April 2016, we haven't included it in this guide yet.
You are a 0% credit card tart
It's arguable that those who are financially savvy, with top credit scores, strict organisation and timekeeping who disloyally shift from 0% credit deal to 0% deal (see the best balance transfers guide) should also pay their mortgage off before their credit cards, as even with balance transfer fees that undercuts most mortgages.
This strategy should only really be adopted by the extremely financially competent (eg, stoozers) though. For anyone else, it's generally best to clear card debts first, even at short term 0%.
You aren't allowed to overpay a loan
Many loans are structured repayments, which means you have a designated amount to repay each month, over a fixed term. While you are allowed to clear the debts in full (though there can be small repayment penalties for doing so), many older loans do not allow you to make monthly overpayments.
However, a change in rules came into place on 1 Feb 2011 which mean you'll be able to make partial overpayments on loans taken after this date. Banks may charge you for this, however only up to 1% of the amount repaid (if the loan is for over a year) or 0.5% (if under a year).
For anyone with loans from before Feb 2011, even though it's likely to be more expensive than your mortgage, if you don't have enough funds to clear the debt IN FULL you may want to use any savings towards your mortgage instead.
However if you are close to having enough to clear the loan, and will be able to get the whole amount together soon, it's likely to be worth waiting.
From this point on, we'll assume you're free of all other more expensive debts and have spare cash.
Do you have a sufficient emergency fund?
Good old-fashioned budgeting logic says it's always worthwhile having a cash emergency fund. While for people with expensive card and loan debts we generally disagree (see Use Savings To Repay Debts?), for those who are debt-free, apart from a mortgage, this is a good idea.
Overpay most mortgages and the cash is gone. So if the roof leaks or boiler bursts you may be forced to use expensive credit cards instead. Your earlier overpayments won't stop lenders charging you for being in arrears if you miss monthly repayments (see mortgage arrears help guide).
So it's always a good idea to keep an emergency fund in savings - three to six months' worth of cash is a good guide, enough to live on if you lost your job or had other issues. If you're thinking of using newly arriving extra income (such as a pay rise) to overpay your mortgage, then build up an emergency fund first. As a minimum...
Put enough aside to cover mortgage repayments for at least six months
This applies even if the calculator shows you'd be better off overpaying your mortgage. It's what's known as 'a premium for liquidity'. In other words, it's sacrificing some interest for easy access to cash when needed.
The exception to this is for those with flexible or current account mortgages
The exception - mortgages with flexible features
Mortgages with flexible features (including offset or current account mortgages) allow you to overpay and borrow-back. So you can overpay the mortgage, then withdraw cash without penalties if you need it again. If you have one of these, there's no problem putting all spare cash in the mortgage - it can be used like a high-rate savings account.
Don't misread this as saying everyone should go for one of these mortgages. The problem is their interest rate is usually higher than standard mortgages, and for many the extra cost of the mortgage debt more than outweighs the gain on savings. See the Ultimate Mortgage Calculator to do a comparison for you plus see the Mortgage and Remortgage guides.
Can you cut the cost of your mortgage?
It's worth checking to see if your mortgage is over-expensive before making the decision.
If you can get a cheaper mortgage, it may change the result. Take a quick look at the Cheap Mortgages or Cheap Remortgages guides.
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Paying off a mortgage versus saving
Before getting on to mortgages specifically, it's important to understand the basic principle of how all debt and savings interact. Borrowing and saving are two sides of the same coin...
The difference is the amount it pays us is usually far less than the amount it charges us, that's one way it makes its profit (see the Should I Repay Debts With Savings? guide).
| �1,000 debt On a credit card at 18% | The interest cost is: �180 |
| �1,000 saving
In a savings account at 2% after tax | The interest earned is: �20 |
This all seems very simple with credit cards, but it can seem much more complex when it comes to home loans, so let me spell it out...
A mortgage is a debt. It may have special properties, but it is a debt just like any other.
So here's the same graphic as above, this time for a mortgage...
| �10,000 mortgage debt at 5% | Annual interest cost: �500 |
| �10,000 saving
at 2% after tax | Annual interest earned: �200 |
So here while the difference between the cost of the mortgage and the gain from Top Savings is smaller than with other debts, it's still significant. Plus this is at basic rate tax, those paying higher or even top rate will find the gap much bigger. Therefore we get a very simple rule...
If your mortgage rate's higher than after-tax savings interest you'll profit by overpaying it rather than building savings
Should I pay off my mortgage?
Part of Martin's showreel, but should start at correct point
Video Courtesy of Make Me Rich, ITV, 2006
Tool - is it worth repaying your mortgage?
To really cement this, start to think of overpaying your mortgage as a form of saving. Take repaying a 5% mortgage...
To earn �500/year after tax on �10,000, a basic rate taxpayer needs an account paying 6.25%, higher rate 8.33% & top rate 9.1%
These are phenomenal, gobsmacking, unheard of amounts that you simply can't get safely in any normal account, which shows just how profitable overpaying a mortgage can be.
Should I repay mortgage with savings?
Once the calculator tells you what savings rate you need, check out the Top Savings Account or Top Cash ISA articles to see what's currently available.
For the vast majority of people, making extra mortgage repayments wins (though as noted earlier, always ensure you've used your cash ISA allowance first).
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Calc: How much will you gain by overpaying?
Working out the savings made by overpaying your mortgage isn't simply a matter of chopping the lump sum repayment from your balance. It cuts future interest and hopefully will mean you're mortgage-free much earlier.
The overpayment calculator below will help reveal your savings. Remember though, you also need to work out how much interest keeping your cash in savings would have earned over the same time period, and subtract this from your profit for overpaying.
Time mortgage overpayments correctly
Mortgage companies have three ways of calculating the interest you owe - daily, monthly or annually. Check your mortgage to see which it is - though thankfully the majority of new mortgages are on daily interest, which is better for you as an overpaying borrower.
The less frequent their calculations, the more important it is to plan the timing of your overpayments. With monthly, and especially annually, calculated mortgages, it's crucial to time any extra repayments correctly for one simple reason.
Mortgage overpayments will only count AFTER the calculation's made. Put it in at the wrong time and you'll miss out.
| An extreme example should help to simplify this... | ||||||||
|---|---|---|---|---|---|---|---|---|
| Done wrongly | Done right | |||||||
| Mortgage type | Annually calculated | Annually calculated | ||||||
| Mortgage rate | 5% interest | 5% interest | ||||||
| Calculation date | 2nd May | 2nd May | ||||||
| Amount overpaid | �10,000 | �10,000 | ||||||
| Overpayment date | 3rd May | 1st May | ||||||
| Interest reduction over year | Nothing | �500 | ||||||
In this example, if you missed the annual date you'd be better off putting the money in a top Cash ISA or Instant Access savings so you're earning interest in the meantime. Then arrange to make the mortgage overpayments a few days before the calculation is made.
If you have a substantial lump sum to overpay, ask the mortgage company if it will automatically make a calculation, even if it's not the calculation date. Many will do this for you, though you may need to be overpaying a minimum of around �500 - �1,000.
The above all applies to interest-only mortgages too - if you make overpayments lenders should apply this to the outstanding debt, and cut your monthly interest payments from the next calculation date. If your overpayment significantly dents the debt, it may make moving onto a 'repayment mortgage' an affordable option.
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Key alternatives to overpaying
If it all adds up that overpaying is the right option for you, there are a couple of other things worth considering flirting with before you take the plunge. We're not saying "these are better" - but we'd be a little remiss if we didn't at least nod to them.
Consider filling up your cash ISA allowance
Every year, each UK adult is allowed to save a lump in a cash ISA (�5,760 in 2013/14 tax year), which is effectively a tax-free savings account. The fact the interest isn't taxed means the gain from this can mean it outweighs the cost of mortgage debt, or at least closes the gap compared to other savings.
However, even if it doesn't add up to put cash in a Top Cash ISA now, it's worth noting if you don't use your cash ISA allocation in a given tax year, you lose it. And remember once cash is in an ISA, it's then tax-free year after year until you take it out, and you can do an ISA transfer in future to keep rates high.
Therefore you may decide that it's worth taking the small financial hit now to earn a little less with your money, in order to fill up your cash ISA allowance while you can. This also means your cash remains more liquid and available.
Is it worth investing rather than saving?
Now we hit interesting territory (forgive the pun). Investing means putting the money in a financial product that involves taking a risk in the hope that the money will grow more quickly, although it could lose.
While our calculator shows that for many it's very tough to find savings that beat overpaying a mortgage, the same isn't true with investing.
A top-performing investment will pay substantially more than 10% a year, yet one that performs badly can lose serious amounts of money too. This includes putting cash into your pension or buying more property (possibly as a buy-to-let) rather than paying off your home loan. If it goes well you'll gain, if it goes badly you'll lose. There are no guarantees.
We don't cover what to invest in as there's no right or wrong answer, only how to buy investments the cheapest way (see Cheapest Way To Buy Shares, Cheapest Way To Buy Funds) so we won't be taking you much further along this road. If you need help on this, seek Independent Financial Advice.
However, investing isn't wrong. Done well it's very profitable, provided you understand the risk you're taking.
Yet to generate the amount of investment returns equivalent to paying off your mortgage, you'd usually need relatively high risk investments - while overpaying the mortgage gives a surety of return
Isn't paying off a mortgage investing in the property market anyway?
No. Buying a house in the first place is investing in the property market. Repaying your mortgage more quickly is paying off an outstanding debt. While the two acts are part of the same thing, by repaying your mortgage more quickly you're not altering the state of your investment - your house is neither more nor less likely to rise or fall in value.
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