Updated 22 March 2022
Low-interest rates mean savers are earning just pennies on their nest eggs. There could be a better way to use your spare cash, and one answer is overpaying on your mortgage instead.
When interest rates hit rock bottom, savers lose out. The Bank of England base rate is currently 0.1%, and many banks match this low offer. It’s a pretty miserable situation, given that this rate is below inflation, meaning savers will lose money in real value.
The good news is, savings aren’t the only way to save per se. By overpaying on your mortgage, you could reduce your debt and save money that way. You’d be making gains at the same rate as your mortgage. So, if your mortgage rate is 3%, for example, that’s the equivalent of savings that would earn 3% in interest.
Sounds like a win-win – but is it always the savvy move? We look into the benefits and disadvantages of overpaying on your mortgage below.
The most obvious plus-side of paying off more of your mortgage is that you’ll reduce your debt and bring yourself one step closer to living mortgage-free. Perhaps what is less obvious is that you’ll bring down the amount of interest you pay, too.
Say you have £150,000 left of a 20-year mortgage with a 3% rate. If you overpay a lump sum of £15,000 (that’s 10%), you will pay off your mortgage two years and seven months early. Plus, you’d save £11,210 in interest.
The likelihood is that the amount you save by overpaying your mortgage is much higher than you’d currently earn from savings. Using the example above, let’s say you keep the £15,000 cash in a 0.1% simple interest (not compound) savings account. You’d earn just 15 quid on it a year. And if interest was compounding monthly, you’d still only earn £180.99 annually. That makes the £11,210 in saved interest from overpaying the mortgage even more appealing.
Overpaying your mortgage could help you cut your loan-to-value (LTV). This is the proportion of your property price covered by your mortgage. It goes down if your property value goes up and as you pay off more of your mortgage. That’s why overpaying can help bring it down.
A good reason to bring down your LTV is that lenders use this figure to decide which deals they’ll offer you. The lower your LTV, the lower the interest rates you can access. So overpaying on your mortgage could mean that you get an even cheaper deal when you come to remortgage.
Most fixed-rate mortgages come with an initial tie-in period, during which you can’t leave the deal without being penalised by a fee. The same applies to if you overpay on your mortgage, meaning you could be ‘fined’. These are called Early Repayment Charges (ERC), and they’re usually between 1% and 5% of the balance.
If you’ve got a £150,000 mortgage, even 1% will sting you with a £1,500 ERC. However, if you’ve got a £50,000 mortgage, 1% would only leave a £500 dent in your pocket, which may be worth it if you could cut down the balance and the interest by a significant amount.
There is also usually some leeway. Most lenders will let you overpay by around 10% a year during the tie-in period, which you can do in chunks or monthly overpayments. Don’t just take our word for it, though. Check your mortgage details before you overpay.
Wiping off your mortgage debt may be a big ambition, but it’s important that you always have some emergency cash available. If the pandemic has shown us anything, it’s that you really can’t know what’s around the corner. Generally, it’s a good idea to have three to six months’ pay (after tax) at hand, but ideally 12 months’ pay. You could need it for all sorts of reasons, from unexpected house repairs to covering your living costs if you suddenly can’t work for any reason.
However, this doesn’t necessarily apply if you have a flexible mortgage, like an offset or current account one. These give you the option to borrow back money you’ve paid off, so you won’t be strapped for cash if you overpay.
There are other ways you could get around the current meagre interest rates.
Shop around for better savings rates – although most current accounts won’t offer rates to be desired, some savings accounts could deliver reasonable returns. To give you an idea, NatWest and Royal Bank of Scotland currently have accounts that offer 3% on up to £1,000. Hunting out the best deals could help to protect your cash from rising inflation.
Pay off more expensive debt – your mortgage may be the biggest debt you have, but it might have a lower interest rate than other debts. Credit cards, unsecured loans and overdrafts can be much more expensive, and it’s generally advised to pay these off first.
Top up pension pot – if you have spare cash, putting it into your pension pot could be sensible as you’ll get tax relief on it, and it will be invested to help it grow. There’s no limit on how much you can pay into your pension, but only up to 100% of your salary or £40,000 attracts tax relief.
Remortgage to get a lower rate – another way to save money on your mortgage is to switch to a better deal. Given widespread low rates, changing deals could make your mortgage much cheaper. Just watch out for the ERC if you’re still in the tie-in period.
If you’re still unsure what to do, you should speak to a mortgage broker or an IFA. They’ll give you a clear snapshot of your options and help you search out the best deals.