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Overpaying the mortgage versus saving: what's best?
Overpaying the mortgage can knock year and thousands of pounds off the cost of your mortgage.
by Michelle McGagh on Dec 19, 2012 at 13:45
Paying down debt before saving is a financial planning ground rule, but does this apply to paying off your biggest debt: your mortgage?
Everyone knows that paying the minimum on the credit card each month will mean that it will take you longer to pay off the debt and you will rack up more interest in the process.
Due to the interest mark-up it is prudent to overpay the minimum in order to try and get the credit card bill back down to zero, and the same applies to the mortgage.
Overpaying the mortgage is an alien concept to many people, who see their monthly mortgage payments as just another bill that goes out each month. However, the mortgage isn’t just another bill, it’s a debt, and the quicker you pay it off the more money you save.
Saving versus overpaying
As the mortgage is considered a monthly outgoing rather than a debt, many people are accumulating savings but still paying the minimum on their mortgage. It’s always a good idea to have some easily accessible money in reserve but is it a false economy to keep saving when the mortgage payments are knocking minimal amounts of the total home loan?
Jason Holmes, director of Lumen Financial Planning in Northern Ireland, said you need to strike a balance between savings and paying your mortgage.
He would not recommend throwing all your savings at your mortgage, but instead keep an emergency fund back to cover any large, unexpected outgoings. Depending on your circumstances, it is recommended that you have three to six months of monthly expenditure saved – so if your monthly bills are £1,000 then you need to have between £3,000 and £6,000 in easily accessible savings.
Holmes said whether you overpay or save depends on your mortgage rate and what interest rate you can achieve on your savings.
If your mortgage rate is higher than what you’d get from your savings then it is better to overpay, but if the situation is reversed and you are benefiting from a savings rate that is higher than your mortgage, then you should save.
‘Lots of clients are paying low interest on their mortgage and can get a better return by saving in the bank,’ said Holmes, adding that everyone will have to judge it against their own personal circumstances as mortgage rates and saving rates will differ.
Benefits of overpaying
Holmes is overpaying his own mortgage and hopes to have the balance cleared in seven years, rather than the full term of 16 years.
‘I am paying off my mortgage. My son is 11 and in seven years he may want to go to university but instead of saving for it I will have paid off my mortgage and will have extra money to help him with living expenses,’ said Holmes.
‘Even if my son doesn’t go to university, it means my mortgage is paid off. You are paying less interest on your mortgage and there is no investment risk – you are just building up equity in your property.’
He added that even a small amount of overpayment can make a large dent in the term of the mortgage and the interest paid.
The average house price in the UK is just below £250,000, if you assume the homeowner has put down a 10% deposit and has a mortgage of £225,000, taken out over a 25-year term and paying 3% interest.
Assuming the interest rate doesn’t change over that time the homeowner will pay £1,067 per month and the total amount paid back, repayment of the loan plus interest, will be £320,093 – that’s £95,093 in interest.
By overpaying £100 per month, the mortgage will be paid off in 21 years and the total repayment falls to £307,350, saving £12,743 in interest.
If the overpayments hit £250 per month, the loan will be paid off in 18 years and cost £293,639 – a saving in interest of £26,454.
Free up your money
Holmes said that many people are worried about using their savings to pay off the mortgage because ‘they think they will never be able to save that amount again’ but what they need to remember is they will have more spare cash once the mortgage is repaid.
Just as Holmes wants to use the money freed up by ditching his mortgage to help his son if he chooses to go to university, releasing yourself from the burden of a mortgage can help you achieve more.
‘Mentally, paying off the mortgage gives people a freedom, especially if you have a spouse who wants to reduce the amount they work. Getting rid of the mortgage frees people up to decide what they want to do with their lives,’ said Holmes.
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