Just when we thought interest rates couldn’t get any lower, the Bank of England moved to mitigate any potential fallout from Britain’s decision to leave the European Union by cutting them further to 0.25 per cent. Bad news for savers but very definitely good news for the country’s borrowers, particularly those on variable rate or tracker mortgages. Making mortgage overpayments is an option worth considering.
But is it a good idea to take advantage of these record low rates? Here are some things to consider:
Do you have debts charging higher interest rates?
Your mortgage is likely to come with the lowest interest rate of all of your debts. That’s because it is repaid over 25 years – sometimes longer – and the total amount you will repay is large. It’s also secured against your house meaning that the lender has more confidence that it will be repaid. You’re likely to have loans and credit cards charging much higher rates of interest so it always makes more sense to pay off these more expensive debts before reducing your mortgage.
Can you get more by saving?
It’s unlikely given the record low interest rates we’re enjoying but it is just possible that some savings accounts – like ISAs or National Savings – could pay you more in interest than you are having to fork out on your investments. These also give you tax-free returns. It depends on the size of your outstanding mortgage balance and the rate that you are paying.
Should you pay more into your pension?
If you have £150,000 outstanding on your mortgage, are paying 5 per cent interest and still have 25 years to go, then overpaying by £5,000 will reduce the interest you pay in total by £11,500. But that will take you into retirement and that £5,000 might actually get you more of a windfall if you put it into your pension scheme.
What about simply shortening my mortgage term?
There’s actually little or no difference between shortening your term or making higher repayments. The only major difference is that shortening your mortgage term locks you in to making higher repayments for the remaining life of the loan.
Making mortgage overpayments is more flexible
If you are on a variable rate with your mortgage, then if and when interest rates rise your costs are going to increase. If you have chosen to shorten the length of your mortgage, then you might find that you can no longer afford the cost of the repayments. But if you’ve simply made mortgage overpayments when rates are low, then not only will have you reduced the total interest that you will have to repay, you’ll also be able to revert to the agreed amount of your monthly repayment.
When overpaying is not appropriate
Don’t simply jump straight in to making overpayments on your mortgage. Read the small print of your mortgage agreement – you might find that there are financial penalties levied by the lender in the form of redemption payments or interest rate hikes if you make higher-than-expected payments. If you don’t have a financial emergency fund (at least three months of living expenses) in the bank, then you might be better advised to start building one up before tackling your mortgage.
Remember that if you do make overpayments, this won’t affect how you are viewed in the future if you get into financial difficulty. Your mortgage lender will still be able to put you into arrears, issue a default notice or start repossession proceedings should you fail to keep up with future payments.
Your lender may decrease following payments
This is particularly relevant if you – like most mortgage holders – make your repayments by direct debit. Don’t assume that your lender will not respond to your making mortgage overpayments. Some lenders will automatically reduce the payments that it takes from borrowers for the rest of the calendar year when they make overpayments. This is to protect the total amount of interest that the lender will get at the end of the mortgage term. If in doubt, check with your lender before starting to make overpayments.
Watch the timing
Your lender may calculate interest on your mortgage daily, monthly, quarterly or annually. While most will calculate daily – which means that you’ll benefit immediately if you overpay – some lenders don’t and you should always check to find out when interest is calculated before make mortgage overpayments. This is because there is little point making an overpayment until just before interest is calculated. If your interest is calculated annually in April, for instance, and you make an overpayment in May, then this won’t have any effect on the outstanding balance for a whole year.