Using your spare cash or a windfall to pay off part of your mortgage might not sound like the most exciting way to spend your money. But overpaying on a home loan can deliver significant benefits in the long run.
How overpaying works
“If you want to overpay on your mortgage, you can either do so with a lump sum – for example money you have received as an inheritance or a redundancy payment – or by making regular additional payments every month,” says Chris O’Brien, product development manager at NatWest. In some cases there may be limits on the amount you can overpay in any given year, but O’Brien recommends talking to your bank to check your overpayment options.
“If you are managing your mortgage online or through an app, you may also be able to organise overpayments in this way,” he says. You don’t need to commit to making regular overpayments – it is normally possible to overpay whenever you want, provided you stay within any annual limits.
Mortgages are typically set up to run for a fixed period of time, and the size of monthly repayments are based on the amount borrowed, the current rate of interest, and the length of time remaining.
By overpaying, borrowers reduce the balance of their loans and, therefore, the monthly repayments are generally reduced to reflect this. Alternatively, it may be possible to reduce the length of time the mortgage is scheduled to run if you choose to keep your monthly payments the same. Reducing your mortgage balance means that the total amount of interest paid over its course will be lower.
What impact can overpaying have?
Online mortgage overpayment calculators can clearly demonstrate the impact that additional payments could have on the length of your loan and the total amount of interest you are charged.
Take the example of a mortgage of £150,000 with 20 years left to run and a current interest rate of 4% a year (standard variable rate). At the moment, monthly repayments would be £909. But by paying an extra £50 a month, if the monthly payments remained the same the term of the mortgage would be reduced by 18 months, saving a total of £5,807 in interest – assuming that the 4% remained in force for the duration of the loan.
Meanwhile, overpayments of £100 a month for the remainder of the loan term would shave almost three years off the mortgage and reduce interest costs by £10,677. Alternatively, making a lump-sum payment of £10,000 would cut just under two years from the mortgage term, and save £11,400 in interest.
“Some borrowers consider overpayments so they can reduce the length of their mortgage to bring it in line with life events, such as retirement or children going to university, when the extra money might be especially useful,” says O’Brien. “And it is worth bearing in mind that mortgage interest rates are at the moment relatively low by historic standards. If rates were to rise significantly in the future – say in five or 10 years’ time – the potential benefits of overpaying today could be even greater.”
O’Brien says that people who manage to remortgage on to a loan with a cheaper interest rate may decide to maintain their monthly repayments at their existing level in order to reduce the term and overall interest bill. “Or it could just be the case that you have received a salary increase at work, and would like to use the extra income in this way.”
Overpaying versus the alternatives
O’Brien adds that the returns currently available on bank savings mean that, for many people, overpaying can seem attractive. “Interest levels on deposit accounts have been low since the financial crisis, and in any case the rates paid by borrowers are invariably higher than those available on savings accounts,” he says. “As such, many people may think it makes sense to use spare cash to pay down their mortgage as the returns will ultimately be greater.”
It should be remembered, however, that putting extra money into paying off your mortgage means that that cash cannot easily be accessed. If you decided that you would like to have a £10,000 lump sum overpayment back to use for another purpose, for example, you would have to remortgage your home in order to get it.
And savings are not the only alternative use of a windfall or extra monthly income: it can make sense to prioritise the likes of pension pots or long-term investments. Although stockmarket-linked investments carry higher levels of risk, they may also offer higher potential returns than might be realised through reducing your mortgage term and interest levels.