The very idea of being mortgage-free sets many a homeowner’s heart a flutter. Overpaying on your mortgage will get you closer to that goal, whether it is through making a lump sum overpayment or paying a bit extra each month. But does paying off your mortgage make more sense than putting the money in a savings account?
“The first thing to look at is whether you have enough savings in place to begin with,” says Kevin Neil, chartered financial planner at Clarion Wealth Planning. “As a general rule, you should aim to have between three to six months’ income saved in an easily accessible account, to cover any emergencies.”
If you already have adequate savings and want to start thinking about clearing your debts, it still might not make sense to start with your mortgage. “If you have any credit cards or personal loans, then you should usually start with these, as they are likely to have higher rates of interest than your mortgage,” Neil says.
With a rainy day fund in place and more expensive loans shrunk, it may be time to consider reducing your mortgage. You will need to check though, that repaying will not cost you more than you actually save.
“First of all, find out if it is an option that is open to you,” says David Hollingworth of London Country Mortgages. “There may be some penalties for early repayment. A fixed-rate mortgage without penalties for repayment is quite unusual, for example. However, a lot of lenders will allow you to repay up to a certain amount, typically 10% of your outstanding balance per annum.”
For it to make sense to put your money into a savings account rather than pay off your mortgage, you would need to achieve higher interest rates on your savings than you pay on your mortgage.
Interest rates on savings accounts are pitifully low, with best buy instant access savings accounts paying around the 2% mark and that’s before tax. The chances are you are paying more interest on your mortgage than you would earn on savings. Best buy variable rates for new mortgages are around 3% or more, while if you have finished a deal and are on your lender’s standard variable rate you might be paying as much as 5%.
As you pay income tax on interest on all savings outside of [some retirement saving schemes], you need to take that into account too. With a mortgage interest rate of 4%, a basic rate taxpayer would need to find a savings account paying 5% to achieve a higher rate on savings than is being paid on the mortgage. A higher rate (40%) taxpayer would need 6.7% on savings and an additional rate taxpayer (50% until April 2013, 45% thereafter) would need 8%.
If you are in a position to overpay on a monthly basis, the savings are attractive. Based on a 150,000 repayment mortgage over 25 years at a rate of 3.5%, if you were to overpay just 50 a month you would save 7,976 in interest and pay the mortgage off two years and three months earlier than planned.
Overpaying 100 each month would save 14,379 in interest and pay the mortgage off four years and three months early, while monthly overpayments of 200 would save 24,045 in interest and pay the mortgage off seven years and three months early.
If you have a 100,000 mortgage with a 4.5% interest rate and a 20-year term, and you pay off a 5,000 lump sum, you would save 6,873 and pay your mortgage off one year and seven months early. Pay off 10,000 and you would save 12,967 in interest and pay off your loan three years and one month early. Overpay by 30,000 and you will save 31,238 in interest and be mortgage-free eight years and one month sooner than planned.
Pros and cons of overpaying
Even if you can only make a dent in your home loan, there are very real advantages to reducing your mortgage debt and increasing the amount of equity in your home. If you come to remortgage or to move later, you will be able to access much lower interest rates if the size of your loan is worth less than 60% of the value of your property, for example.
However, while you can slice thousands off your loan and improve your chances of getting a good deal in the future, there is a potential downside. “The big cautionary note is that if you overpay on a bog-standard mortgage, in order to release funds you will have to remortgage,” Hollingworth says. That will take time, and with stricter lending criteria it may not be easy.
If you think you might need the cash back any time soon, do not use it to repay a home loan that you cannot extend again.
Guardian News and Media 2013