As she knelt at my feet I looked down and saw she was about to stick me with a sharp blade. But the next moment saw the podiatrist treating my ingrowing toenail ask the question that prompted me to write about the sheer power of mortgage overpayments.
"I hope you don't mind me asking," she said, "but my finances are in a good state and I've got a cheap variable rate mortgage. So I was thinking of shortening my mortgage term to clear it quicker. Is that a reasonable thing to do?"
Thankfully, as it's never a good idea to argue with someone holding a scalpel, this is an eminently sensible move. Decreasing the term means you clear the loan more quickly, so there is less time for interest to accrue, meaning the overall cost decreases.
Yet as I started to nod, I quickly checked: "I presume you can't just overpay?" She told me she could, in fact she had a mortgage with fully flexible features, so she could pay as much as she liked without penalties.
Great news for her finances, and more importantly, explaining her options gave me something to focus on (and to man–up about) during the toe torment.
Overpaying has the same impact as shortening the term
Overpaying and shortening the mortgage term do exactly the same thing. Yet overpaying has the advantage that you can stop it if you want or need to. Time for a bit of number crunching (all done using the mortgage overpayment calculator – feel free to try it with your own circumstances – the results can be shockingly powerful).
On a £200,000 repayment mortgage with a 25-year term at 4.5% interest, the monthly repayment is £1,110 (so that's £13,300 a year). Over 25 years the total amount you repay is £334,500.
Shorten the term to 20 years, and the monthly repayment rises to £1,265 (£15,200 a year). Yet over the 20 years the total amount you'd repay is just £304,700. So while shortening the term increases the monthly repayment, it cuts the total interest cost by £29,800 – a monumental saving.
However you can virtually replicate the effect by simply overpaying the difference in the monthly amount between the two – £155 a month (£1,860 a year). I write ''virtually'', as timing issues over when the interest is calculated can have a small impact.
However, some lenders do try to negate this. As Philippa replied to my discussion on this topic via Facebook: "I've been overpaying for a couple of years. I do it in the months I can afford to and it makes a big difference. Beware, though: my mortgage provider automatically reduced my monthly payment as a result. I had to ask it to reduce the term instead."
If your mortgage provider alters your repayments to keep the term the same, although it will boost your monthly disposable income, you won't save on your interest payments, and the lender will earn more. So be sure to tell it to keep your monthly repayments fixed.
The boon of overpaying is flexibility
Let's head back to my podiatrist for a moment. Her mortgage offered an overpayment facility as standard, yet no mortgage offers a ''shorten the term'' facility, and with the recent introduction of stringent affordability criteria for mortgages – even if you toe the line (sorry), being allowed to shorten the term is far from guaranteed.
Yet she'd also achieved the great feat (sorry again) of bagging a cheap variable rate mortgage. This means when interest rates rise, as many predict they will by early 2016 (though that doesn't mean they're right), her monthly costs will rise, and could mean that her current sensible plans to shorten the term become her Achilles heel (last one, I promise).
Let's imagine she has a £200,000 mortgage remaining over 20 years, currently at 2.5%, and her monthly repayments are £1,060 a month. Cut the term to 15 years and they rise to £1,330.
Now suppose UK interest rates go up and her mortgage jumps to 4.5% – her repayments would rise a further £200 a month. If UK rates rose to pre–credit crunch levels, then her mortgage rate would be 7.5%, a possibly unaffordable £1,850 a month.
Of course the aim then would be to lengthen the term, but there's no guarantee a lender will allow it. With overpaying, there's far more freedom of control.
Overpaying isn't for everyone
Not every mortgage allows you to repay penalty free, and if there are penalties they will almost certainly kill any gain from doing so. Even if you are allowed to overpay, amounts are usually restricted, for example to 10% of your outstanding amount per year.
Even then, there are a few key questions to ask yourself before embarking on it...
- Do you have other debts? While a mortgage is likely to be your biggest loan, it's unlikely to be your most expensive. If you have other debt at higher interest, use any spare cash to clear that first, as it is costing you more. See the should I clear debt with savings? guide for more.
- Will overpaying beat saving? The simple rule of thumb is that if your mortgage rate is higher than the after-tax rate you can earn on savings, overpaying wins.
Now do note that I write "what you can earn" not "what you do earn". If your savings rates are poor, first check what you could get elsewhere. Right now the top pick savings rate pays 3% on up to £20,000 with the Santander 123 bank account – a net return of 2.4% for basic taxpayers, 1.8% for higher rate.
To cement this, think of overpaying your mortgage as a form of saving. Take repaying a 5% mortgage. If you cleared £10,000 of it you'd save £500 a year in interest – to earn the same amount from savings, a basic rate taxpayer needs an account paying 6.25%, a higher rate one 8.33%, and a top rate one 9.1%. These are unheard-of amounts you simply can't get with any safe savings accounts.
Thus, overpaying wins for most people. Yet those with very cheap legacy tracker mortgages, or those with enough equity to bag a super low current rate at 1%-2%, it may not. If that's the case, then build up your savings, but have them accessible so that you can make a lump sum overpayment if interest rates rise and your mortgage is no longer relatively as cheap.
Of course, some will say you should invest, not save, to earn more. That can work, but it's not a like-for-like comparison. Like saving, paying off a mortgage gives a guaranteed return, while using the cash for investing may mean huge returns or losses.
- Can overpaying get you a better mortgage deal? Even if the difference between overpaying and saving is trivial for you, there is another possible benefit. Having a smaller mortgage can mean you get a cheaper mortgage deal.
The key metric for lenders is the Loan to Value (LTV) amount – the size of your borrowing relative to your home's current value. The lower, the better. Overpaying reduces the amount you owe and therefore may enable you to remortgage at a better deal – use the mortgage best buy comparison to see what's available for you.
Mathematically, in some rare cases this may be even more lucrative than paying off expensive loan and credit card debts, because getting your massive mortgage debt a little cheaper can outweigh continuing to pay a higher interest rate on a smaller debt.
The time to focus on this is if you're close to one of the key LTV thresholds – the point at which acceptability increases substantially and cost drops. These are roughly 95% LTV (above this and you won't be able to remortgage at all), 90%, 85%, 80%, 75% and 60%. Dip below any of these thresholds and mortgage deals get cheaper.
To take a simple example, if you have a £200,000 home and £19,000 equity, your LTV is 90.5% – the best two-year fix for this is 4.05%, meaning your repayments are £12,100 a year. Yet if you contribute £1,000 of your savings to reduce the LTV to 90%, the best two-year fix (with similar fees to the first) is 3.19% meaning your mortgage repayments will be just £10,500 a year.
- Do you have a cash emergency fund? Even if the maths trumpets that overpaying is a winner, before dunking extra money into your mortgage, consider building up an emergency fund of six months' worth of bills in an easy-access savings account.
This way, if something happens, you've got the cash put aside to deal with it rather than it being locked away in a mortgage. It's important to understand that if your finances hit a brick wall and you're struggling, the fact that you've been happily overpaying for years won't stop lenders putting you in arrears.
Those with a flexible mortgage who are allowed to borrow back overpayments needn't be as wary, although since the affordability criteria began last April lenders may refuse to let you borrow back, even if its terms originally stated this.
The one fly in the ointment with all this is inflation. Historically money devalues over time, therefore paying £1,000 off your mortgage now is in real terms more expensive than paying £1,000 off your mortgage in 20 years' time. So this is one argument against overpaying.
However, right now inflation is very low and in general, mortgage interest rates are higher than both inflation and savings rates. So as a ''use of money'' choice, overpaying is still very beneficial. Inflation will diminish the gain a touch, but overpaying usually still leaves you with a gain.
Time mortgage overpayments correctly
Mortgage companies have four ways of calculating the interest owed: daily, monthly, quarterly or annually. Thankfully, most new mortgages use daily interest. If not, you need to time overpayments carefully.
To use an extreme example, if you had a mortgage that only calculated the interest owed on 1 March and you overpaid on 2 March, it would have no impact for 364 days, and you'd have been better off putting it in a savings account.
So time your overpayment for the day before interest is calculated. For more information on the logic behind this see the should I overpay my mortgage? guide.