Repay mortgage?

It’s a common dilemma, whether to pay more off a mortgage or save? While overpaying usually wins, there can be spanners in the works… repayment penalties, need for emergency funds or even just high savings rates. This step-by-step guide will help you decide and includes the ‘Should I overpay my mortgage?’ calculator.

• The key rule
• Clear other debts first
• Repay mortgage v saving
• The Should I Pay Off Calculator
• Correctly time repayments
• When not to repay
• What about investing?

The answer is in there somewhere!

For most debts, the rule’s pay ‘em off with savings

Before getting on to mortgages, it’s important to understand why most people with both debts and savings are seriously overspending. It’s simply because the cost of debt is usually much higher than the profit from saving.

The main exceptions are where there are penalties for clearing the debt, as is common with loans, or if the debt is so ridiculously cheap you can make more money putting it in a high interest savings account, as with 0% credit cards (see the Stoozing Guide). For more on other debts, read the Should I Pay Off Debts With Savings? guide.

Which debts to clear first

It naturally follows that you should clear the most expensive debts first, that way the interest doesn’t grow as quickly, saving you cash.

Mortgages are cheap compared with most credit cards or loans, so focus on repaying them before your mortgage.

The exceptions to the rule

As with any rule of thumb there are bound to be exceptions

• If you’re struggling to remortgage

  If you’re looking to remortgage, having a smaller mortgage can mean you get a better deal. Therefore if you’ve got savings, and can use it to significantly lower your mortgage borrowing, which gets you a cheaper rate, it can be worth doing even ahead of paying off more expensive debts.

  That’s because getting your massive mortgage debt a little cheaper can outweigh paying a higher interest rate on a smaller debt.

• Student loan debts

  By this I mean the official loan from the Student Loans Company. This is because the interest is set at the rate of inflation, making it the cheapest possible long term debt, so it’s rarely worth paying off any more quickly than is necessary (see Student Loans: Should I Pay them off?).

• Credit Card Tarts

  It’s also arguable that if you’re a good credit card tart and constantly rotate debts on 0% cards, there’s no need to pay these off quicker either, but this strategy should only be adopted by those who seriously play the balance transfer tarting system.

From this point on, I’m going to assume you’re free of all other more expensive debts (that you’re able to repay more quickly) and have spare cash.

Paying off a mortgage versus saving

The first thing to understand, is something many people simple don’t accept.

Your mortgage is a debt. It may have special properties but you must think of it as a debt just like any other.

Even for a basic rate taxpayer, while the difference between the cost of the mortgage and the gain from saving is smaller than with other debts, it’s still significant and that’s compared to a Top Savings Account. Higher rate taxpayers, or those with worse savings accounts, will find the gap much bigger.

So based on maths, if your mortgage rate’s higher than the after-tax savings interest, don’t save, overpay the mortgage.

Having said that, before making this decision it’s worth checking to see if you can cut the cost of your mortgage, see the Cheap Mortgages Guide or Cheap Remortgages Guide for more on that.

The ‘Should I pay off my mortgage?’ video clip

Watch out for cash ISAs

Every year, each UK adult is allowed to save up to £3,600 in a cash ISA, which is effectively a tax-free savings account. The fact the interest isn’t taxed means the gain from this usually outweighs or equals the cost of mortgage debt.

Add to that the fact that if you don’t use your ISA allowance each tax year, you lose it; it’s worth filling each year’s ISA up before repaying the mortgage. Though do ensure you’ve got the top cash ISA or it skews the maths.

The ‘Should I repay my mortgage?’ calculator

To really clear it up, take this a step further and think of ‘paying off your mortgage' as a form of saving. To earn £600 a year after tax on £10,000 in a savings account, a basic rate taxpayer would need an interest rate of 7.5% and a higher rate taxpayer an enormous 10%.

This is a phenomenal, gobsmacking, unheard of amount that you simply can't get safely in any normal account (some Regular Saver Accounts pay this much but only on a very limited amount of cash and tend to have bizarre terms), which shows just how profitable overpaying a mortgage can be.

Once the calculator tells you what savings rate you need, check out the Top Savings Account or Where To Start With Savings 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).

Even if savings pay more, overpay if it’ll get you a better mortgage

Even if it works out better to save, there’s one exception that’s been caused by the credit crunch . That’s because those who haven’t paid much of their mortgage debt off are struggling to get decent new deals (see the Remortgage guide for more).

For those with an LTV (Loan to Value ratio) of over 90%, meaning your mortgage debt is at least 90% of the house’s value, getting a new mortgage has become very difficult. For those with an 80% to 90% LTV you should get a new deal, but it won’t be too cheap.

Therefore if you have savings, and can use them to significantly lower your mortgage borrowing, enabling you to get a better deal, it's often worth doing. The extra amount your savings will earn isn’t likely to be as much as the benefit from a cheaper mortgage.

Always correctly time mortgage overpayments

Mortgage companies calculate the interest owed on a mortgage daily, monthly or annually; which one makes a huge difference. With monthly, and especially annually, calculated mortgages, it’s crucial to time any extra repayments correctly. Money put towards the mortgage only counts after the calculation is made; so don't put your money in too early as it won't have an impact and you'll miss out on interest you could’ve earned in a savings account.

Those with interest only mortgages need to be careful. Normally the repayments only go towards repaying the interest of the loan, not the capital (the actual amount you borrowed). So ensure any extra payments you make specifically go towards decreasing the capital (in other words decreasing the actual debt) to attract less interest.

Checklist of when to pay

First establish how the mortgage interest is calculated; call the lender and ask if need be. If it’s daily there’s no problem. If it’s monthly, quarterly or annually, ask for the date the calculation is made.

Then rather than making mortgage overpayments willy-nilly, simply move it into the top instant access savings or instant access cash ISA, 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, if it will, fantastic.

Now for the reasons why you shouldn’t!

It all sounds good so far doesn’t it? Simply dosh the money into the mortgage. Unfortunately it’s not that simple, there are a number of things to check first.

Are you allowed to repay your mortgage more quickly?

Some mortgages penalise you for paying them off more quickly, especially if you have a special offer fixed or discount rate deal (see the Cheap Mortgage or Cheap Remortgage guide).

This is because lenders want you to stick with them once the cheap rate ends, as at that point their rates shoot up. Thus it’s not in their interest to let you pay off the mortgage more quickly – after all the longer it takes you to repay, the more they earn.

Check whether there are any penalties or additional costs to making extra or higher repayments. If there are these are likely to outweigh the gains from repaying the mortgage in which case it’s time to start saving. Thankfully these penalties are becoming rarer, though most mortgages will allow you to make “overpayments” (i.e. paying more than the regular amount) in some form.

Can you get to the money if needed?

Put your money into most mortgages and it's gone - you're effectively locking it away, losing the ability to use it in the future. Therefore the interest gain must be balanced against this limited flexibility and the concept that you've no cash to call on if needed.

A cash 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 I generally disagree (see Should I Pay Off My Debts?), for those who are debt free apart from a mortgage, this is a good idea.

It’s worth having three to six months worth of cash stored away. Enough to live on if you lost your job or had other issues; even if mathematically you would be slightly better off repaying. Mr Hallis, my A Level economics teacher would probably have called this “a premium for liquidity”, in other words you’re sacrificing some interest for easy access to the cash if needed.

Consider the potential outcome with no emergency fund. Put all your cash in the mortgage, and if something happens and without savings you would need to fund this with credit card or loan borrowing for easy quick cash – and that’s expensive. Therefore only start dumping cash in the mortgage once your emergency fund is up and running.

This has become more pertinent with recession looming. If you overpaid now, then left your job and couldn't meet standard mortgage repayments, you'd go into arrears. So...

Ensure you've enough cash put aside to meet mortgage repayments for at least 6 months

Worst still, lenders are hitting those with arrears hard, often pushing towards repossession (see the debt help guide). Therefore ensuring you've enough money put aside to meet mortgage repayments is crucial.

The exception mortgages with flexible features

Some people have mortgages with flexible features (or super-flexible offset or current account mortgages), meaning you can overpay or borrow-back (i.e. put the money in to pay off the mortgage but then withdraw it without penalties when you need it). If that's the case there’s no problem putting all spare cash in the mortgage – as it can be used as a high rate savings account.

This may prompt you to think flexible mortgages are therefore always best. Yet the problem is their interest rate is usually higher than standard mortgages, and the extra cost of the debt more than out-balances the gain on savings for most people. Full details on this and whether it's right for you are in the Mortgage and Remortgage guides.

What about 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, but it could lose.

While the calculator shows it’s virtually impossible for most to earn more interest by saving than 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 buying more property, possibly as a buy to let, rather than paying off your home - if it goes well you'll gain, if it goes badly you'll lose; there are no guarantees.

At this point I should point out, I 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 won’t be taking you much further along this road.

However, investing isn’t wrong. Done well it’s very profitable, provided you understand the risk you’re taking. To hope to generate the amount of investment returns equivalent to paying off your mortgage, you’d need relatively high risk investments; yet paying off the mortgage gives you a surety of the return.

Isn't paying off your 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.

Paying off your mortgage over the long term can have a serious impact on the cash in your pocket. With a £100,000 remaining on a 5.5% mortgage over 20 years, repaying an extra £100 a month clears the mortgage in just 16 years, saving £14,500 in interest.

The same £100 a month in a savings account, even at a very high 6%, would only earn a basic rate taxpayer £9,450 over the same time period or a higher rate taxpayer £6,660.