Mortgage Guides

Should I overpay my mortgage or boost my savings?

Updated: Tuesday 29 November, 2011

By Martin Fagan

Households with surplus income they wish to put to good use agonise over whether to pay down their mortgage or boost their savings. We consider the pros and cons of both.

Even in such cash-strapped times, some households are fortunate to have disposable income and, rather than fritter it away on fripperies, they want to make this spare cash work for them in the most efficient way possible.

• Low interest rate “windfall”
• The banking industry’s “3-6-3” rule
• Pay off your credit cards first
• Saving vs Overpaying your mortgage
• What overpaying your mortgage would save you
• What a savings account would pay you
• So how would I be better off?
• Don’t forget inflation...
• And don’t for get to check with your lender...
• And finally...

Low interest rate “windfall”

One of the chief household financial “windfalls” of recent years has been that, as the Bank of England has lowered the base rate to 0.5%, people on tracker, variable-rate or lender standard variable rate (SVR) mortgages have seen their monthly payments reduced.

For example, someone with a £150,000 repayment mortgage charged at a rate of 7% in September 2007 (when base rates were 5.75%) would have had a monthly payment of £1,072.63. Since March 2009 when base rates hit the historic low of 0.5%, the average rate is 3.9%, making the monthly repayment £791.71, a theoretical saving of £280.92 a month.

While many borrowers see this monthly windfall as an opportunity to increase their spending on what economists call “non-discretionary items”, others see the extra cash as a way of salting away some savings or else maintaining their original monthly mortgage payment, paying down their mortgage and, ultimately, saving on interest payments.

So at some point, they’ll ask themselves the question: “should I use the money to overpay my mortgage or boost my savings?”

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The banking industry’s “3-6-3” rule

The natural temptation is to assume the money you save in a deposit account will work harder for you than throwing it in the raging financial furnace that is your mortgage. On deposit, if you have an emergency call on your cash, you can get the money out. If you overpay your mortgage, unless you have a flexible mortgage that allows you to claw back overpayments, the money’s gone.

But it would be a mistake to think that the money is “lost”; you may not feel the benefit of it immediately, but it will have a positive impact on your finances further down the line. But first, here’s the rationale behind this.

One of the perennial tenets of banking is that interest charged on money owed is always higher than interest paid on money saved. Despite the sleight-of-hand sophistry that some financial services providers indulge in, the “3-6-3” rule still applies as it has done for over 100 years - money taken in as savings at 3% is lent out as mortgages at 6% and the bank manager is teeing off on the golf course at 3pm.

OK, the numbers may change - and the fact the bank manager will now mainly play golf at the weekend rather than in business hours - but the principle remains the same - borrowing will cost you more than saving earns. And because the fall in interest rates to an historic low has made saving relatively unrewarding, paying down your mortgage by overpaying is possibly the most profitable thing you can do with any spare cash.

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Pay off your credit cards first

Before you can even consider using spare cash to overpay your mortgage or depositing it in a savings account, do a quick audit of your personal finances as consider any outstanding debts, specifically credit cards. If you have an outstanding balance on any credit card, the interest rate charged on this debt will be in some cases four or even five times greater than the rate charged on your mortgage.

Think of it like this - every £1,000 of debt on a credit card is like adding almost £5,000 to your mortgage. So the first thing to do with any spare cash is pay off short-term borrowing. Once that’s done, if you still have spare cash every month that you’d like to get working for you, then you can consider whether saving the money or using it to overpay your mortgage is the best course of action.

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Saving vs Overpaying your mortgage

Using current market averages, the average variable rate mortgage is charging 3.5% and the average rate on a no-notice variable-rate savings account is 2.25%. Your mortgage is a £150,000 repayment mortgage, the term is 25 years and the monthly repayment is £750.94. You’ve decided that you can afford an £100 extra a month.

So, do you overpay £100 a month on a mortgage charging 3.5% or deposit £100 a month in a savings account paying 2.25%? Let’s see how the numbers run. Please remember that although the principle remains the same, the actual figures quoted are relevant to this example and not to your specific financial circumstances. This is an example only - to see how you’ll benefit, you’ll have to do your own sums.

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What overpaying your mortgage would save you

Overpaying £100 a month (£850.94 a month in total) would mean you pay your mortgage off not in 25 years but in 20 years and eight months, saving you four years and four months of interest payments, a cash saving of £14,378.81.

But many people look at the total overpayment of £24,796 (£1,200 a year for 20 years and eight months) and wonder why overpaying costs you over £10,000 more than the interest you’re supposed to be saving. Investing £24,796 for a return of £14,378.81 doesn’t sound like too much a good deal until you compare it with the returns from savings accounts.

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What a savings account would pay you

If you paid £100 a month into a savings account paying 2.25% a year interest, in 25 years (by not overpaying, we assume the mortgage runs its 25-year term) you’re investment would be worth £40,295.71, far more than the sum saved by paying off the mortgage. No brainer, eh?

But there are several very important factors to bear in mind. The money on overpaying the mortgage is interest saved on money owed. With the cash saved, it is interest earned on money saved and to get the interest we first have to subtract the original capital. Saving £100 a month for 25 years means £30,000, so subtract that from £40,295.71 and you’re left with an interest total of £10,295.71.

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So how would I be better off?

So saving interest by overpaying the mortgage is £14,378.81 and earning interest on your savings earns £10,295.71, a difference of £4,083.10. But that’s not all. If you saved in a regular savings account, all interest will be taxed at a rate of 20% deducted before you get it. This results in the “real” return on your savings being 1.8% (not 2.25%), which means at that rate, if you subtract your £30,000, you’re left with interest of £4,067 rather than a saving of £14,378.81 if you overpaid your mortgage.

Another factor to consider is the length of time the returns are calculated over. Because overpaying gives you considerably better returns over a shorter period of time, this means overpaying your mortgage by £100 a month costs you less in outlay - £24,796 is the cost of overpaying compared with the £30,000 you pay into a savings account, a further saving of £5,204.

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Don’t forget inflation...

The final element to factor in is inflation, the rate at which money loses its purchasing power. Inflation ravages the real value of savings. If your savings rate is 1.8% but inflation averages out at 2% per year (it’s currently 4.5%), your savings will still be worth £34,067 but their purchasing power will be only £20,764.89.

The higher the rate of inflation, the greater the erosion of the spending power of your savings. According to the Office for National Statistics (ONS), during the last 20 years (August 1991-August 2011) inflation has increased by 51%.

Inflation may erode the value of the money you’re using to overpay your mortgage, but the value of the asset the mortgage is funding - your home - is increasing faster than inflation. If inflation has risen 51% in the last 20 years, over the same period house prices (as measured by the Halifax house price index) have increased by 243%.

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And don’t for get to check with your lender...

Although most mortgages taken out in the last five years have an built-in flexibility which includes overpayments, some lenders have restrictions on how much you can pay back a month or annually before being penalised by fees.

For example, some lenders allow only a maximum of 10% or 20% overpayment each month, so if your normal monthly repayment is £1,000, you can only overpay a maximum of £100-£200 per month. It’s best to check your intended level of overpayment is allowed before arranging an increase in your direct debit mandate.

Also, check how frequently the interest on your loan is calculated. You’re looking for an interest rate that’s calculated daily, so every overpayment has an immediate effect in reducing the amount you owe so it generates less interest for you to pay. Therefore, borrowers with a daily interest mortgage will see the benefit of a lower interest charge as soon as they make an overpayment.

Overpaying is not such a good idea if your mortgage is calculated annually, especially if you intend to overpay each month. This is because if you miss the annual calculation date by even a day, your money sits in the lender's coffers until the end of its financial year until it recalculates the rate, which means you’re effectively giving the lender an interest-free loan.

Mortgages that calculate interest annually are declining, but they do exist. Before you commit to overpayments, make sure yours isn’t one of them.

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And finally...

For most people, their mortgage is their biggest financial commitment and anything that reduces the cost of repayments or foreshortens the mortgage term, thereby saving a considerable number of interest repayments, is one to be welcomed.

Overpaying your mortgage not only saves you thousands of pounds in interest but also puts you ahead of inflation. It’s also one of the smartest ways you can make spare disposable income work hardest for you.

The short-term benefits of overpaying your mortgage may be invisible but, in the long term, the savings are profound.

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