In the balance: with rates rising, is overpaying your mortgage a good move?

In the balance: with rates rising, is overpaying your mortgage a good move?

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Rising interest rates have pushed mortgage overpayments to their highest levels in more than 20 years as householders struggle to reduce their debts.

Many people with money to spare are choosing to reduce the amount they owe in an effort to tackle the spiralling rates that have left so many others with huge bills once their fixed-rate deal ends and they go on to a new product.

But, at the same time, many banks are offering the best deals on savings accounts in years. So is overpaying your mortgage a good way to deal with the threat of bill shock? Or are you better off putting any spare money aside in a savings account?

How does it work?

Mortgage repayments are not set in stone. They can often be increased, so that more is taken off the total amount owed, and therefore the term of the mortgage is reduced.

The last two years have seen turmoil in the financial markets. Since December 2021, interest rates have gone from 0.1% to 5%. As a result, lenders have increased the cost of borrowing, and many people who have come off cheap fixed-rate deals have faced huge increases in the amounts they have to pay.

There has been a big increase in the number of people overpaying in an attempt to reduce their debt burden. For example, £6.7bn was overpaid in the last three months of 2022 after the September mini-budget, which was the first time the quarterly figure has exceeded £6bn since 1999, says the Equity Release Council.

David Hollingworth of broker firm L&C Mortgages says people who are on a fixed rate should make preparations now for when it ends.

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“Although rates could ease back if inflation is brought back under control, there is no guarantee as to when that may be, and it doesn’t spell a return to the historic lows of base rates that we’ve been used to in recent years,” he says.

He adds: “Adjusting the amount of a monthly budget allocated towards the mortgage will help to squeeze more value out of the current deal. That could be through making overpayments each month, or saving a regular amount to build up a fund that can be used to reduce the mortgage at the most appropriate moment.”

The advantage of overpaying is that money will not only be taken off the total, but also interest will not have to be paid.

Adam French of NerdWallet, a financial advice site, says that the higher the rate, the bigger the savings with an overpayment.

“If you have a mortgage debt of £250,000 over 25 years, assuming this remained on 2%, making a one-off overpayment of £10,000 will save £6,257 interest over the lifetime of the mortgage, and reduce the term by a year and three months,” he says.

“But a £10,000 overpayment, on the same £250,000, at 6%, will save £31,723 over the lifetime of your mortgage, and reduce the term by two years and one month.”

What are the limits?

Lenders typically limit the amount people can overpay on fixed-rate deals – traditionally it is capped at about 10% a year. But this depends on the lender.

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“Most deals will carry an early repayment charge during the fix, but the majority will have a facility that allows a certain degree of overpayments without incurring a penalty,” says Hollingworth.

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“It will typically be 10% of the balance each year, but it can be more depending on the lender. For example, NatWest recently moved to 20% a year for all borrowers, and Metro and Atom Bank are offering up to 20%. That will usually give plenty of flexibility.”

Where the borrower has the money, they can avoid any limits or fees when they come off their fixed rate, as standard variable rate (SVR) mortgages – you usually default on to the SVR – typically don’t have any restrictions. So, in theory, you could come off a fixed rate, make an overpayment and then sign up to another fixed-rate deal.

Sophie Waugh, at mortgage adviser John Charcol, says someone coming off a fix with a £200,000 mortgage with 25 years remaining, would pay £1,609 a month on an SVR of 8.49%.

“In comparison, if you were to take a new two-year fix at 6.18%, your monthly payment would be £1,310. For many, this would be a large increase from their most recent payments.

“For each of these rates, if you were to pay off £20,000, this would take the monthly payments down to £1,448 and £1,179 respectively.”

Why not just save?

Rates on savings accounts and Isas are at their highest levels in years, leading many to see what they could make by putting the money away, compared to taking it off their mortgage.

A key rule, put forward by Martin Lewis’s MoneySavingExpert, is that if your mortgage rate is close to, or higher than, a savings rate, then it is a good idea to overpay.

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“Given just how low some mortgage rates will have been, and the fact that savings rates have been rising, it may make sense to consider whether putting the cash into a savings account would deliver a return that could outstrip paying off the mortgage,” says Hollingworth.

“When considering that, it makes sense to not only look at whether the savings rate exceeds the mortgage rate, but to factor in any tax on the interest.

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“The personal savings allowance will often mean that isn’t a problem, but with rates climbing, it could affect more, especially higher-rate, taxpayers.”

Another advantage of overpaying is that it can decrease the property’s loan-to-value (LTV), meaning that better rates may be secured when it does become time to take on a new fixed deal.

But overpaying is not for everyone. It is important to ensure you always have enough cash in savings in case of an emergency. And if there are more expensive debts – such as credit cards or loans – it is vital these are cleared first.

MoneySavingExpert warns borrowers who are committed to overpaying that they should tell their lender that they want to reduce the term of the mortgage. After that, overpayments can usually be done via online banking.

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