If you have extra money at the end of the month, should you pay off your mortgage in full or would it be better to put it into savings or a pension?
In 2023, UK mortgage rates hit their highest points since 2008.
According to Moneyfacts, the average two-year fixed mortgage rate is over 5 percent, up from the 2 point 34 percent average rate in 2021, even with the recent Bank of England interest rate cut.
The estimated 1 million homeowners whose fixed rate mortgages are set to expire this year will probably be concerned about this. The monthly payments for a new mortgage will be higher and the cost will be much higher.
The housing market and household finances will have been significantly impacted by the increased borrowing costs.
Here are some things experts advise you to consider if you have a mortgage agreement that was signed before interest rates began to rise.
Is it appropriate to make excessive mortgage payments?
According to Jo Jingree, MD of the mortgage advice company Mortgage Confidence, there are a number of factors to take into account before choosing to overpay your mortgage.
The most important of these, she says, is whether you have enough money saved to get through a financial emergency. "It's a great idea to overpay your mortgage, but only if you have a sizable amount of savings first and foremost," she continues.
Additionally, think about whether your lender will charge you an early repayment fee for the overpayment. Most lenders permit overpayments of up to 10% or even 20% of your balance annually, but not all do, so always check before making an overpayment.
How to avoid paying too much for your mortgage.
1. Pay off debts with a lot of interest
Laura Suter, AJ Bell's head of personal finance, advises anyone considering overpaying on their mortgage to first settle costly debt, such as credit card bills or overdrafts. When you have savings and interest-bearing debts, it is almost always more cost-effective to pay off the debts with the savings rather than investing the money in your mortgage.
For instance, a person who owes £1,000 on a credit card at 19% interest despite having £1,000 in an account earning 4% interest. Even though you paid off £100 each month, you would still have to pay £93 in interest on your credit card, while you would earn 4074 interest on your savings over the course of a year.
Thus, using your savings to pay off the debt and avoid paying such a high interest rate is the most advantageous course of action.
2. Establish an emergency fund
After paying off any high-cost debts, you should accumulate enough cash to cover three to six months' worth of expenses. This will help you in the event that you experience an unforeseen financial setback.
You cannot get your money back once you have paid for your mortgage, so make sure you have enough in your emergency savings account first. It's a good idea to have funds in an easily accessible account so you can access them in case of emergencies like a broken boiler.
3. Verify if your mortgage provider permits overpayments
Early repayment penalties are likely to apply to mortgages with fixed or discounted rates, and they may be triggered by overpayments. Any interest savings would be quickly negated by those fees. Therefore, before you begin making overpayments, it is crucial to confirm the policies of your lender.
Up to ten percent of your outstanding mortgage debt may be overpaid annually, according to many lenders. You might be able to overpay more if your mortgage has a variable rate. In most cases, you can increase your monthly direct debit or make one-time transfers to make overpayments.
There are usually no restrictions on overpayment for those whose mortgages are on a standard variable rate, which is the rate to which the mortgage reverts after a fixed term ends. But first, you ought to consult your lender.
4. You might want to change the term of your mortgage
When it comes time to remortgage, you can shorten the term of a mortgage, which means you pay it off sooner, rather than overpaying.
Higher monthly repayments will result, but you will pay off the loan more quickly. This lacks the flexibility of overpaying, though, where you can change the monthly amounts you overpay.
Advantages of making larger mortgage payments.
You will pay less interest on the loan the sooner you pay it off. Overpaying will enable you to pay off your mortgage more quickly by reducing the amount on which interest is actually charged.
Since many people are still able to take advantage of lower interest rates, it might be wise for borrowers to consider taking advantage of those low rates.
Head of lending at Mortgage Advice Bureau Brian Murphy says, "Overpaying each month, even if it is as little as 100, will likely save you money in the long run." Additionally, it gives you greater flexibility because you can easily reduce your payment to the pre-arranged amount if you ever find yourself in a situation where you need the extra money.
"You'll probably be able to pay off your mortgage more quickly and pay less interest if you make a single, sizable payment.
According to Nicholas Mendes, mortgage technical manager at John Charcol, "You can lower your long-term interest costs and reduce the outstanding balance more quickly by making additional payments toward your mortgage principal.
For instance, the monthly mortgage repayments for a person who borrowed £200,000 over 25 years at a 4.5 percent interest rate would be £1,111.
By making a £200 monthly overpayment, you could pay off your mortgage six years sooner than expected and save about £36,281 in interest. Paying off your mortgage three years and six months ahead of schedule and saving about 21,142 in interest would be possible if you overpaid by £100 per month. Mendes continues: "Overpayments on your mortgage essentially accelerate the growth of your home's equity. Whether you choose to release equity for home improvements or move, having more equity gives you greater financial stability.
"You'll be more equipped to manage market swings if you lower your outstanding mortgage balance. A smaller outstanding balance can lessen the effect of rising interest rates on your monthly mortgage payments.
Reducing your mortgage debt with some of your savings may also help you if it lowers your loan-to-value (LTV) bracket.
The majority of lenders offer the lowest mortgage rates to borrowers with an LTV of 60% or less. You may therefore be eligible for a lower interest rate when you eventually remortgage if you used savings to pay off a portion of the mortgage if your LTV was slightly higher.
Excessive pension contributions or mortgage overpayments.
It may make more sense to contribute more to your pension than to make overpayments on your mortgage for a variety of reasons.
"Money invested in a pension will receive tax breaks. Karen Noye, a mortgage specialist at Quilter, adds that it also benefits from frequently having long-term stock market investments, taking advantage of compound interest's magic and having the potential to weather market volatility.
The tax break alone is worth a lot. On your self-assessment tax return, higher or additional rate taxpayers claim relief at either 40 percent or 45 percent, while HM Revenue and Customs pays you 20 percent into your pension.
Additionally, your money grows tax-free. You might be giving up significant investment growth if you prioritize mortgage payments earlier in life.
The way your pension is invested determines how much it increases annually. However, according to a recent study by Pension Bee, for those 30 years out of retirement, pension funds have been providing an average annual growth of almost 8% over five years.
"This does add up, even if pensions grow between 2 and 3 percent annually, over a long period of time and with a larger amount in the pot," says Murphy of the Mortgage Advice Bureau (MAB).
Furthermore, it is likely that mortgage rates will decline again, even though they will remain high in the near future. Thus, paying off your mortgage with all of your extra money might not be the best course of action.
"Historically, investing in the stock market has yielded a higher return, especially when done through a tax-efficient product like a pension," Noye says. Therefore, it might be wiser to contribute more money to your pension if you are paying more than just the basic rate tax because of the combined benefits of tax relief and fund growth over the long run.
Interactive Investor conducted a study in 2024 that examines various scenarios and calculates the relative importance of pension contributions and mortgage overpayments.
An example of a person with a £200,000 mortgage over a 25-year period, with £200 left over each month, and assuming interest rates stay the same is shown in the table below. Here are the potential changes in their results based on whether they prioritized mortgage overpayments or made pension contributions first.
Premises: 20 percent tax relief and a mortgage with a 25-year payback period. Overpayment of £200 per month into a pension or mortgage is option 1, 2, and 3. Option 1 and Option 3: After the mortgage is paid off, transfer the funds to a pension, which will yield returns net of investment fees.
Since interest rates fluctuate, it may be more prudent to concentrate on savings, mortgage overpayments, or pension contributions at different times, as noted by Myron Jobson, senior personal finance analyst at Interactive Investor.
Another important factor to take into account is the impact of tax breaks on pension contributions. Jobson states: "Delaying increasing your pension wealth may result in that you receive less tax relief if you are a higher rate taxpayer. If you contribute a significant amount to your pension in a short period of time, you may not earn enough in the future to qualify for a higher rate of tax relief.
How can I pay my mortgage in excess?
You can begin planning your overpayments as soon as you know how much you can overpay without incurring penalties.
Your lender may have already contacted you to go over the limits, but it's still crucial to let them know you will be overpaying, how much, and when.
Either make a one-time payment or schedule recurring installments to be made to your mortgage account.
On an interest-only mortgage, is it possible to overpay?
You can typically make overpayments on interest-only mortgages in two ways: as a lump sum or as higher monthly installments.
The capital will typically not decrease, so you will continue to pay interest on the entire amount borrowed each month.
However, the excess payments ought to immediately lower the remaining loan balance, resulting in a lower total repayment amount.
Similar to a repayment mortgage, you will need to be aware of overpayment limits to avoid triggering an ERC if your current loan is still within the fixed period.
Is it better to make monthly or annual overpayments on my mortgage?
You will pay less interest if you chip away at the total amount you borrowed.
Therefore, it's best to have a lump sum at the start of the year. However, a monthly overpayment is the best option if you are unable to do that.
Before proceeding, discuss your plans with your broker or lender.
The decision on whether to overpay your mortgage.
There is no one-size-fits-all solution in financial matters. Your priorities, situation, and risk tolerance will all influence your course of action.
It might be more appealing to contribute to your pension and allow interest to compound rather than pay off your mortgage right away if you believe that ultra-low mortgage rates will return.
Keeping this additional money in an easily accessible savings account might make more sense if you anticipate needing it for any reason in the near future.
A number of variables will affect the computations, including your age, mortgage term, mortgage product, and available savings rates. Before making these choices, it is still advisable to seek professional advice.
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