Homeowners with spare cash to save have been given a new dilemma with interest rates soaring.
Do they put the money into one of the top new savings accounts being launched? Or do they try to pay off some of their mortgage to keep the cost of their debts down?
Many households built up a savings habit during the pandemic and are considering their next move.
Shrewd move? You can typically overpay your mortgage by 10% each year without penalty. You simply need to contact your lender if you want to start
Here, Money Mail explains how to work out whether overpaying on your mortgage is the right choice for you.
Trick to slash your home loan costs
Not everyone knows you can typically overpay your mortgage by 10 per cent each year without penalty.
It’s not complicated to set up the payments. You simply need to contact your lender if you want to start.
Most will usually let you overpay a single lump sum or boost your monthly payment.
If you have no outstanding expensive credit and can tick the boxes in the panel, right, then it could be worth considering overpaying.
Makala Green, a financial planner at Schroders Personal Wealth, says: ‘In the past, mortgages have been seen as “good debt”, but with rates soaring they are actually becoming expensive debt.
‘Those on low mortgage rates should think about reducing at least some of it before they are moved on to a higher rate.’
The impact on your finances will be greatest over the long term.
With mortgages, you inevitably end up paying back considerably more than you borrowed — and the higher the interest rate, the higher your total bill.
For example, if you had 20 years left on a £250,000 repayment mortgage at a rate of 2 per cent, you would end up paying back £303,530, including interest, overall, according to broker L&C Mortgages’ repayment calculator.
Long-term benefit: With mortgages, you inevitably end up paying back considerably more than you borrowed – and the higher the interest rate, the higher your total bill
But if the rate was 4 per cent, you would pay back £363,588 — a huge £113,588 on top of your original loan.
By paying off more of the debt in the earlier years, you bring down the size of the loan on which interest is charged.
For example, if you paid off an extra £200 per month for two years on that £250,000 mortgage with a 2 per cent rate, you could save yourself £2,184 in interest, according to analysis by Interactive Investor. This shaves five months off your total mortgage term.
With the same overpayment and mortgage with a 4 per cent rate, you would save £5,339 in interest and shorten your mortgage by six months.
By overpaying early, you bring down the size of your debt which in turn brings down the amount of interest you are charged.
If rates continue to rise, the more interest you’ll save by repaying your balance earlier.
Overpayment to unlock new rate
By overpaying your mortgage, you will chip away much more quickly at what is owed and could qualify for a lower loan to value (LTV) deal when your fixed-rate ends.
LTV is the value of a home compared with the amount you need to borrow when remortgaging.
This can unlock slightly lower rates. For example, Virgin Money is offering those remortgaging 5.43 per cent at 60 per cent loan-to-value, compared to 5.94 per cent for those wanting 80 per cent LTV.
Chanelle Pattinson, a financial planner at Money Means, says: ‘Lenders see borrowers with lower LTVs as less risky, so may offer slightly more preferable rates.’
If you only have a few years left on your mortgage, the impact of overpaying will be less significant than if you start overpaying earlier.
You won’t qualify for better LTV deals and the potential interest savings will be small. So, if you are close to the end of your term, it may be more worthwhile to divert the cash into investments, pensions or savings for retirement.
Timescale: If you only have a few years left on your mortgage, the impact of overpaying will be less significant than if you start overpaying earlier
How to work out the key sums
Now to the key question: should you overpay the mortgage or save into a cash account?
First, check how your mortgage rate compares to the best savings deals on offer. Just as mortgage rates have gone up, savers deals have also become more attractive over the past few months.
Say you have a mortgage rate of 2 per cent and can get an easy-access rate of 2.5 per cent. If you put £200 a month into a savings account paying 2.5 per cent, you would earn £117 in interest over two years.
By comparison, if you overpaid £200 a month for two years of a £250,000 mortgage fixed at 2 per cent, you would save yourself £93 in interest over the two years, however this would snowball to £2,184 by the end of the 20-year mortgage.
For the same mortgage fixed at 4 per cent, £200 monthly over-payments over two years would save you £189 in interest, rising to £5,339 by the end of the mortgage term.
This means that savings on interest could be far higher if you are forced to take on a higher rate in two years.
However, savings rates are not expected to rise as fast as mortgage rates.
Most major lenders have a mortgage repayment calculator on their websites to crunch the figures.
If you have a lump sum, the question is: do you pay off some of the mortgage or put it into a fixed-rate potentially paying 5 per cent? On a balance of £5,000 paying 5 per cent over two years, you’d gain £525 interest.
If you’d paid a one-off £5,000 lump sum on your mortgage with a 2 per cent rate, you’d save £195 in interest over two years, according to L&C Mortgages.
