Mortgage Guides

Should I pay off my mortgage early?

Updated Tuesday 13 September, 2011

By Martin Fagan news@consumerchoices.co.uk

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Sometimes a cash windfall - lottery win, redundancy, insurance payout, an inheritance - tempts people to rid themselves of their biggest debt by paying off their mortgage.

But, cash windfall or not, should you pay it off in one feel swoop? Or overpay to reduce the mortgage term and save on interest? We assess the situation...

For most people, their mortgage is not only their biggest debt, but the monthly interest payment is probably their biggest financial commitment. So speeding up its demise by overpaying - or getting rid of it altogether - is a tempting prospect, especially if you receive a sudden cash windfall.

Pay off other debts first

Most people seeking to pay off their mortgage have usually received a recent cash windfall, have accumulated savings or had an investment mature.

But most people have debts as well as a mortgage and, as mortgages are long-term borrowing with lower rates of interest, you’ll probably be better off settling short-term debts first.

For example, £1,000 on a credit card charging 18% a year will cost you a further £180 to service the interest, whereas a £1,000 of mortgage debt charged at 6% a year will cost you £60 in interest. So paying off the credit card is a more efficient use of your cash than paying £1,000 off your mortgage.

Even if you have savings, using them to pay off credit card debt is better value than leaving the cash on deposit. Bank of England base rates are at a historic low - 0.5% since March 2009 - so £1,000 in a savings account paying 3% (after tax) will net you £30 in interest while every £1,000 on your credit card costs you £180. Therefore, using the £1,000 in savings to pay off £1,000 of credit card debt immediately saves you £150.

Overpay the mortgage every month

Instead of paying off your mortgage entirely, one option you may want to consider is mortgage overpayment. Overpayments are simply additional payments that you can make on top of your monthly repayments. They may be made on a regular basis (every month) or in less frequent lump sums, but they will dramatically reduce the length of your mortgage, as well as the amount you pay back in interest.

For example, a mortgage of £180,000 at 6% over 25 years will have a monthly repayment of £1,175. Overpaying by £20 each month will knock one full year off the mortgage term and save you £8,000 in interest over the reduced mortgage term. The more you can overpay, the more you save. If you can manage an extra £100 a month, over the life of your mortgage you will reduce the mortgage term by four years and save £31,000 in interest.

Do your sums

If you’re lucky enough to receive enough cash to pay off your mortgage and own your home outright - or even enough to reduce your mortgage debt by a significant amount - before you write that cheque, do your sums to see if this is the wisest use of the cash.

If you’ve settled any other outstanding debts apart from the mortgage, use some of the money to establish a financial safety net. If fate has blessed you with a cash windfall, it might also blight you with a calamity such as illness, unemployment or other circumstances where you can’t work and earn the money to pay the bills. For those who are debt-free (apart from a mortgage), keeping six months’ net (after tax) salary on deposit as an emergency fund is a smart move.

But after you’ve paid off all your debts and put that financial safety net in place, if you still have spare cash, the interest rate paid on savings (after tax) is always lower than the interest rate on your mortgage so, economically, you’re better off paying off some or all of the mortgage than saving.

For example, if the rate on your mortgage was 6% and you kept the mortgage and banked the windfall then, to earn the equivalent rate of return, a basic rate taxpayer would need a savings account paying 7.5% and a higher rate taxpayer would need a rate of 10% (both after tax has been deducted from the interest paid), both rates impossible to achieve in the current financial climate.

Watch out for redemption penalties

If you’re convinced you want to pay the mortgage off early, it’s important to read the terms and conditions of your mortgage agreement before you make a decision – you may find that some providers charge extortionate redemption penalties, meaning it isn’t worth paying it off in a lump sum, even if you do have the funds to do so. This may well be the case if you are on a special deal such as a fixed, capped or discounted rate mortgage.

For a more detailed explanation on redemption penalties and how lenders levy them, read our guide on early repayment charges

And finally...

If you’re considering paying off your mortgage and are unsure if this is the best use of your savings or windfall, you should probably seek independent financial advice from a professional. An IFA will look at all your financial circumstances - savings and investments, debt, pension provision, mortgage - and help you come to the right decision. They’ll charge a fee, but it could be money well spent.