Moneysaving mortgage trick: pay an extra £150 per month now – save £30,000
Moneysaving guru Martin Lewis does the maths and explains how to save tens of thousands on your mortgage, by overpaying just hundreds
Yahoo Finance UK/fotolia – Fixed-rate mortgages have reached record lows over the last year
Great news for her finances, and more importantly, explaining her options gave me something to focus on and man up 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…
On a £200,000 repayment mortgage with a 25 year term at 4.5pc interest, the monthly repayment is £1,110 (so that’s £13,300 a year). Over 25 years the total amount you repay is £333,500.
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 £303,700. 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 them 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.
If you can overpay your mortgage, it’s worth having a play with my Mortgage Overpayment Calculator , which shows the often surprisingly large impact of single or regular overpayments on your mortgage.
The overpayment boon is flexibility
Let’s head back to my podiatrist for a moment. Her mortgage offered an overpayment facility as standard, yet no mortgages offer 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 in the latter part of 2015, 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 2.5pc, 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 4.5pc her repayments would rise a further £200 a month. If UK rates rose to pre credit crunch levels, then her mortgage rate would be 7.5pc, 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 10pc 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.
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 my top pick savings rate is 3pc on up to £20,000 with the Santander 123 bank account a net return of 2.4pc for basic taxpayers, 1.8pc for higher rate. For alternative rates and whether cash Isas win, see mse.me/ topsavings.
To cement this, think of overpaying your mortgage as a form of saving. Take repaying a 5pc 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 6.25pc, higher rate one 8.33pc, and a top rate one 9.1pc. 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 superlow current rate at 1 2pc, 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.
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 95pc LTV (above this and you won’t be able to remortgage at all), 90pc, 85pc, 80pc, 75pc and 60pc. Dip below any of these thresholds and mortgage deals get cheaper.
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 flexible mortgage who are allowed to borrow back overpayments needn’t be as wary, although since the affordability criteria began in 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, as in general mortgage interest rates are higher than both inflation and savings rates, as a ”use of money” choice, it’s 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 March 1 and you overpaid on March 2, 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.
Martin Lewis is a broadcaster and the creator of MoneySavingExpert.com