Should you overpay your mortgage?

Savers have almost doubled the amount of money they hold in savings accounts during the pandemic, but with savings rates remaining low homeowners may be considering using excess savings to overpay their mortgage.

A mortgage is often a homeowner’s biggest debt, so overpaying a mortgage may seem like a good option for those with the available funds. While for some consumers overpaying a mortgage is a great way to becoming debt-free, for others it may not be the best option.

To help consumers decide whether to overpay their mortgage, here we look at the advantages of making overpayments and other options homeowners may want to consider.

A main reason why many homeowners decide to overpay their mortgage is that it allows them to clear their mortgage debt quicker, which shortens the term of the mortgage and reduces the amount of interest paid as a result.

For example , if someone with an outstanding mortgage of £150,000 on a 25-year term at an interest rate of 4.2%* for the entire term, increased monthly repayments by £100 per month, they would save a total of £18,251 in interest and would pay off their mortgage four years early.

In addition to reducing the interest paid on mortgages, using savings to overpay a mortgage will reduce the amount of money held in savings accounts, which for higher rate taxpayers can help to lower the tax paid on their savings.

Under the personal savings allowance, basic taxpayers can earn up to £1,000 in savings interest before having to pay tax, but for higher rate taxpayers this limit is reduced to just £500. This means that if a higher rate taxpayer held £40,000 in a two year bond at a rate of 1.30% they would be above the personal savings allowance and their savings would be taxable.

When considering whether to overpay a mortgage, homeowners should check to see if their current deal allows penalty-free overpayments or if they will be charged a fee. Those prepared to pay a fee should ensure that the overpayment fee does not erase the financial benefits of making an overpayment.

Homeowners looking to lock into a new fixed rate mortgage deal can avoid overpayment fees by reducing the term of their mortgage when they lock into the new deal. For example, reducing the term from 25 years to 20 years will automatically result in paying higher repayments that will reduce the total interest paid.

Once overpayments have been made it is difficult for homeowners to release the money they have put into their homes. So, those who think they may need the money, especially those without a savings safety net, should consider if they want to lock their money into their property.

Another option for homeowners to consider is whether the money would be better off being put into a pension. Pensions grow free of income and capital gains tax if the pension savings stay under the lower of the saver’s yearly earnings or £40,000 a year. As well as this, pensions contributions are eligible for tax relief, which means that for every pound contributed to a pension the Government will pay in a top-up of 20% of the value of the contribution, up to a maximum of the lower of the saver’s annual income or £40,000 per year.

Homeowners undecided as to which option is best may want to consider speaking to an independent financial adviser who will be able to discuss the best option for their individual needs and future financial goals.

A common way to overpay a mortgage is by increasing the monthly repayments. As highlighted above, this allows the mortgage to be repaid quicker, which reduces the amount of interest paid and the term of the mortgage.

Another option is to use a lump sum to repay a chunk of the mortgage. This is often the option preferred by those who have received an inheritance or, more recently, those who have saved more than expected during lockdowns.

It may be worthwhile speaking to a mortgage broker when looking to overpay a mortgage as they will be able to highlight the options available to homeowners.

*APRC example used.