I tend to consider myself as debt-free, having paid off all my credit card, hire purchase and student loan debts a while ago and since then have continued to save the money that I would have used to repay my debts each month. However, if I am honest I am not completely debt-free, as I am only 3 years into my mortgage and have another 27 years of repayments to make.
The other factor is that I don’t really own my own home, as about 90% of it is actually owned by the bank and whilst I will eventually own it outright, for the next 27 years I am going to be repaying the loan, along with the inevitable interest charges.
Having read on This is Money that just by over-paying their mortgage by an additional £100 a month, somebody with a £100,000 mortgage taken out over a 25-year period, with an interest rate of 6%, could save themselves £27,039.37 and reduce the life of the mortgage by six years, the benefits to be gained from over-paying mortgage repayments are beginning to sound very interesting.
Further to this, making over-payments helps to lower the LTV (loan to value) rate, which means that I can secure a better mortgage deal and will have more equity available to trade up to a larger property in the future.
Adding to this the fact that tax relief on mortgages was scrapped several years ago, all seems to make pressing ahead with over-payments the obvious choice.
However, there are a number of different variables to take into account when considering the over-payment route and it is worth considering the following issues to decide whether making mortgage over-payments is right for you:
Good Debt Vs Bad Debt
I’ve always believed that there are two categories of debt:
- Bad Debt – Money borrowed on credit cards, store cards and hire purchase agreements used to buy ‘nice-to-have’ items such as flat screen televisions, brand new cars, holidays or just frittered away on everyday items
- Good Debt – Money borrowed to fund self-improvement or to purchase an asset that will increase in value, such as student loans, business loans and mortgages to buy a home with
As mortgages are long-term loans for large amounts of money, they tend to have much lower interest rates than other ways of borrowing, such as credit cards. For example my mortgage is currently fixed at 6.7%, whilst my credit card has an interest rate of 20.9%.
With any debt repayment situation, it is important to prioritise any additional repayment money towards the most expensive debts first (for more information on debt repayment see this post – Three Step Approach to Clear Your Debt).
Therefore people with credit card debts and short-term loans will be better off focussing on paying those debts off first, before increasing their mortgage repayments.
Type of Mortgage
The type of mortgage and the various terms and conditions of different mortgage deals will also influence the viability of making over-payments:
- Interest-Only Mortgages – With an interest-only mortgage you are only making monthly repayments on the interest of the loan, therefore you need to ensure that any over-payment goes onto the deposit to decrease the LTV (loan to value) rate
- Fixed Rate and Other Mortgage Deals – If you took out a special deal on your mortgage, check the small print as you will probably find you are limited on the amount that you can over-pay each month until the deal expires
- Off-Set Mortgages – With an off-set mortgage you can use your savings to off-set the interest costs on your mortgage. The advantage is that you have the flexibility to access your savings in times of need but you will probably pay a higher rate of interest for the benefit. Speak to your independent financial advisor to find out if an off-set mortgage is right for you
If you do continue down the over-payment route you should check whether your mortgage provider calculates interest daily, monthly, quarterly or annually. If it is daily or monthly then you are ok to make regular monthly over-payments, however if it quarterly or annually you should time the over-payment so that it happens just before your provider makes the interest calculation. In the meantime you should keep the money in a high-interest account to maximise your interest earnings.
Making the over-payment before the interest calculation simply means that it won’t be accounted for and you will lose interest earnings whilst effectively giving your mortgage provider a free loan!
One of the big problems with ploughing all your spare savings into mortgage over-payments is that could be leaving yourself short for emergency funds.
Financial experts tend to recommend that people build up an emergency fund that equates to at least three to six months of earnings equivalent, so that you can cope with problems ranging from a broken-down car through to redundancy, without having to borrow on credit cards or short-term loans.
Ideally the steps should be:
• Pay-off all short-term debts
• Build up an emergency fund
• Begin over-paying on your mortgage
Some people would argue that over time the amount of money that you would have saved from putting all the money into your mortgage repayment and achieving lower mortgage interest payments outweighs the amount of interest earned from your emergency fund.
I would say that they are probably right, however it is important to consider the benefits of having instant cashflow, which is especially appealing in the current economic climate.
If you are saving up an emergency fund, be sure to save it in an ISA (or similar tax-free savings account in your country), so that you do not lose money paying tax on the interest you earn.
Your Current Stage within Your Mortgage’s Lifespan
The most beneficial stage in your mortgage’s lifespan for making over-payments is at the beginning, because at this point the majority of your monthly repayment figure will mainly consist of interest charges.
As you progress towards the end of your mortgage, the interest charges will have dropped in line with the reduced amount borrowed and with such a low cost loan, there may be other higher priority areas to focus your money on, such as saving for retirement.
This is not to say that people with low mortgages should not bother with early repayment, it is just that the benefits will not be as strong and that there may be other financial issues that will have a greater need for your money.
The key thing to remember is that there is no generic right or wrong and all financial decisions need to take into account your own personal circumstances.
My parents for example, are major enthusiasts for paying off the mortgage as early as possible and having done so on the family home, then continued the same principle with their investment properties, literally taking out 10 or 15 year repayment loans to keep the interest charges down. However this approach may not suit everyone and it is best to discuss further with your financial advisor.
Another interesting concept to consider is the impact that inflation can have in potentially reducing the cost of your mortgage.
Say you borrowed £100,000 at the start of your mortgage term, over a 30 year period. Assuming that you continue to pay-off the standard repayment figure each month and don’t move house, the mortgage will be complete and the property will yours outright.
But if you think about the effect of inflation and the way that it de-values cash, in 30 years time that £100,000 may have reduced in value to the equivalent of £25,000 in today’s money and by the same account your monthly repayments will also have reduced in value.
Therefore, one way to look at your mortgage is that you are taking out a cheap, long-term loan, that will become cheaper and cheaper to service as life moves on, assuming you maintain a secure income that rises with inflation.
This is an important thought to keep in mind when considering other financial options for spending your money.
Other Investment Interests
I recently ran a post called ‘Grow Your Wealth by Buying the Right Sort of Assets’ which looked at a theory that economists call ‘opportunity costs’, whereby you have a number of options available and you choose one of them. The opportunity cost is difference in value between the option you have chosen and the next best alternative.
From a financial planning perspective, you could use the money destined for mortgage over-payments to begin making pension payments, so that you have an income to live on when you retire.
When you pay into a pension you receive tax benefits, which essentially mean that for every pound you save into your pension scheme, the government adds as much as 40p. In addition to this you may be part of a corporate pension scheme whereby your company matches your pension contributions. Over a 20 or 30 year period, this seriously begins to add up and forms a great retirement pot.
The key question that you will need to work out with your financial adviser is what is the opportunity cost of over-paying your mortgage against putting your money into a pension scheme or other types of investments?
My Actions Going Forward
Writing this article has really helped me to better understand the pro’s and con’s of over-paying my mortgage. Given my situation, I believe this is the right thing for me to do at the moment, however I strongly believe that it is best to limit the amount I make in over-payments, so that I can balance them alongside my emergency fund and pension savings.
As this is such a topical area, I would be interested to hear your thoughts on mortgage over-payments, so please feel free to leave a comment below.