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Overpaying a Mortgage

How it works - Why it's important

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If you take out a repayment mortgage your lender will split the monthly payment into 2 -

  1. Part goes towards repaying the original loan, and
  2. Part towards paying the interest

But the lender doesn't split the payment right down the middle. So assume you pay £1,000 a month, this does not mean that £500 will be allocated towards repaying the loan and £500 for the interest.

Instead, during the early years the majority of the monthly payment will go towards paying the interest bill with a much smaller part repaying the original loan. Then, as the years progress more money is allocated towards repaying the loan and less towards the interest.

This makes sense because as the total loan amount gets smaller so will the interest levied.

What is 'Overpaying' a mortgage
  • Assume you take out a repayment mortgage of £100,000 over 25 years
  • The monthly payment is £600 and the interest rate is fixed for the length of the deal (this is to make this example easier to understand)
  • Theoretically if you continue to pay £600 every month the total loan will be repaid after 25 years and you will owe nothing

An overpayment is where you pay more than the specified amount per month. The amount of overpayment is up to you, and you can also designate when you wish to pay. For example -

  • In Jan-Feb-Mar you pay £600
  • But in April you up the amount to £675 and then £725 in May
  • Then for the rest of the year you go back to paying £600 a month
  • So in April the overpayment was £75 and it was £125 in May

Now, an extra £75 or £125 doesn't sound much does it? But look at the examples below to see just how effective even a small overpayment of a mortgage can be.

The effects of overpaying a mortgage

Assume the following -

  • £100,000 mortgage at 5.75% (fixed) for 25 years
  • Monthly repayments would be around £630
  • Over the lifetime of the mortgage (25 years) you would pay back a total of £188,732 (the £100,000 initial loan + £88,732 of interest)

But what would happen if every month you paid an extra £50 to make a payment of £679?

  • Total repayment is now £173,713
  • The mortgage would be fully paid off almost 4 years earlier (21 versus 25 years), and
  • A total interest saving of just over £15,000
  • All these benefits for just an extra £50 a month, or £11.53 a week, or £1.64 a day

And what if you overpay by £100 a month - the monthly amount is now £729?

  • Total repayment would be £163,294
  • The mortgage would be fully repaid in just under 19 years, ie 6 years early

What if an extra £250 was paid every month making the payment £879?

  • Total repayment would be £144,842
  • The mortgage would be fully paid off in just under 14 years
How to work out the effect of overpayments on your mortgage deal
What you need is an overpayment mortgage calculator and here are 2 -
  • Excel based spread sheet - The following (see link below) is great, it's not complex but at the same time it requires more information to be entered than the simple option below
  • Simple Overpayment calculator - This calculator gives you a quick back-of-the-fag-packet overview of the figures
So which calculator would I use? Both, I'd use the simple one to first give me a rough idea and then dig deeper into the figures with the Excel spreadsheet.
Points to look out for
Restrictions on overpayments
  • Most mortgages have restrictions on overpayments
  • For example, only a maximum of 10%-20% can be overpaid each month so if your normal payment is £1,000 you can only overpay a maximum of £100 - £200 per month
  • Check with your lender to see if there are any restrictions
Lump sum overpayments
  • A lump sum overpayment is where a larger amount of money is used to repay a chunk of the mortgage in one go
  • For example your job might pay a bonus of £4,000 and you make a one-off lump sum overpayment of £2,000 or £3,000
  • Again, lenders often put restrictions on the amount one can repay, perhaps 10% - 20% of the total size of the loan per year
Important - How does your mortgage lender calculate the interest

Making a monthly overpayment is a complete waste of time if your lender bases their interest calculation on a yearly basis.

Some mortgages will charge interest for that year based on the total amount of the loan at the beginning of the year even though every month the loan is being reduced. For example -

  • On January 1st the total mortgage loan is £100,000
  • Your monthly payment is £1,000 and for this example assume that £500 goes towards repaying the loan and £500 towards the interest bill
  • So on February 1st the total size of the loan is now £99,500 and therefore interest should only be charged on that amount
  • But if the bank calculates interest yearly then you're still being charged as if the loan was £100,000
  • And of course it gets even worse as the year progresses as in December the loan would be £94,000 but the lender charges interest on £100,000
Truly a great racket for the banks if ever there was one - And they can get away with this because they're often selling to an uneducated clientele (uneducated in this sense means in the mortgage/personal finance sense).

So if you add in an overpayment of any amount at any time during the year it's pointless because of how the interest is charged. It's therefore critical to find out how interest is charged on the total loan - Monthly is fine but daily interest calculations are the best.

So what should you do if your mortgage interest is charged on a yearly basis?

Simple, remortgage as soon as possible to a deal that either charges interest monthly or preferably daily - See How to remortgage for more information.

The importance of flexibility when choosing a mortgage

The above points - Restrictions on overpayments - Lump sum overpayments and how your mortgage company calculates its interest are why it's critical to spend time on research when deciding which mortgage to get (or where to remortgage if you're changing your loan).

Basically you want to get the most flexible deal available, even if you don't necessarily need the flexibility at that time. For example -

Anyone can overpay a mortgage if they start thinking small

If you like the idea of overpaying your mortgage then start to think small.

As you've seen in the working examples above even relatively tiny amounts (in relation to the overall size of the loan) can have a tremendous effect on reducing the number of years on your mortgage.

For example, if you look at the total size of your mortgage, perhaps £100,000 or £150,000+, it seems unlikely that £50 or £100 would make any difference at all.

But this is the wrong way to approach the problem. Instead start thinking of small amounts of money like £5, £10 and £20. Then work out how to save this sort of cash everyday, for example -

8 easy ways to save money - Then use the savings to overpay your mortgage
  1. Not buying a Starbucks Coffee 3+ times a week
  2. Having breakfast at home instead of buying it at work
  3. Going cheaper at the supermarket, either buying some own brand products or looking out for special offers, or just stop making those impulse buys
  4. Take the Tube (if you live in London) or Bus once in a while rather than a taxi
  5. Dump your gym membership if you have one and are not making good use of it by going at least 2 times a week
  6. Think about dumping Sky TV if you have it and go Freeview instead
  7. Be more economical with your utility bills, turn lights off when not needed, turn your central heating on for 1-hour less per day (and/or down 1-2 degrees)
  8. Drive slower to reduce your monthly petrol bill

£5 a day is £150 a month. Or £100 a month is £3.34 a day. Now go back and look at the examples above and see the difference that an overpayment of £100 - £150 a month can make.

Thinking small money is therefore the secret to generating easy funds to overpay a mortgage on a regular basis.

A different mortgage overpayment strategy

A mistake that's easily made with overpaying is to use all your excess cash to pay down the mortgage as quickly as possible.

But this can often cause a problem because suddenly you may lose your job or need access to some extra money in a hurry and unfortunately all of your spare cash will have been used to overpay.

Some people therefore argue that a better strategy is to not overpay until you've funded an emergency account which as its name suggests is a savings account that has money to use in case of an emergency such as loss of job.

Then when this account has been properly funded you can then start overpaying your mortgage. For example -

  • Pay £150 a month for 1-2 years into a Cash ISA (the Emergency Account) - a total of £1,800 - £3,600 (plus accrued interest)
  • Then after 1-2 years when the emergency type account is fully funded start overpaying your mortgage

Yes, the mortgage won't get repaid as quickly as if the £150 a month was used to overpay 1-2 years back but you'll have built up an important nest egg.

So if you gave me the choice which strategy would I use -

  • Start overpaying straight away with £150 a month, or
  • Fund the Cash ISA and start overpaying in 1-2 years time?

When it comes to personal finance prudence normally wins so I'd go the Emergency route first.

Mortgage Overpayment Summary
Put simply - overpaying a mortgage, whether each month or just a for a few months of the year is one of the simplest and most effective personal finance strategy out there.

Anyone can do it, all you've got to do is work out how to save at least £50 from your present monthly budget and most readers should be able to achieve that goal easily and with little effort.

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