If you're steadily using surplus cash to overpay your mortgage, it's time to do your sums. You might well be better off saving your cash, instead!
When is your mortgage freedom day? And by that I mean the incredible day that finally, finally home-loan will be all paid off and that extra cash each month is yours, to do with as you wish?
Well, most of us take out 25-year loans, so depending on when you bought your home you're likely to have some portion of this to go.
However, with the base rate currently at a measly 0.5%, many with tracker mortgages are revelling in their now tiny monthly payments, with the most sensible choosing to ignore their "windfall" and throw that extra cash at the mortgage instead.
Overpaying, overpay, overpay
So why overpay? A friend of mine once said that she didn't see the point - they signed up for a 25-year loan knowing they'd have enough cash left over each month for living expenses. Why would they spend even more of their money on their mortgage, giving them less to live on each month?
Well it's all to do with interest. Mortgages can be considered to be massive personal loans, which rack up interest daily. And while your rate may be relatively low, on such a large sum the interest accrued can easily add up to hundreds (or thousands) of pounds, every day.
But with most repayment mortgages you can overpay, typically by up to 10% per year. And this can make a massive difference to that debt. Every pound of that sum that you pay back early is a pound that can't accrue interest. And that means it reduces the term of your loan, so you'll have paid the whole thing back earlier.
Example
For example, if you had a £125,000 25-year repayment mortgage at 5% you'd pay around £730 per month, or £219,221 over the full term.
Overpay by £50 each month and you'll pay back a total of £206,530, saving yourself a whopping £12,691. What's more, this would shave a whopping three years off the term of the loan, meaning you'll have paid it back in 22 years, rather than 25. Fantastic. (You can work out how much overpaying would save you using our very own calculator).
Tracker rates have been dropping
And overpaying is hot news at the moment. With some trackers at an all time low, mortgage payments have been slashed. So while in the example above you may have been paying 5% a few months ago, that could have dropped to 2%, or £530 - saving a whopping £200 each month.
Now, that extra cash would no doubt come in handy, but if you were to use it to overpay your mortgage instead (in the example above), you could save yourself £11,641 over the term of the deal, and reduce the term by 8.2 years, meaning you'd be mortgage free in just 16.8 years! Wow.
Savings rates are creeping up
However, as I mentioned in this recent article, volatility in the money markets has left lenders desperate for our cash - and willing to increase savings rates in an effort to tempt us. So with some fixed rate bonds now hitting 5% or more, could you be better off saving your cash rather than reducing your homeloan?
Saving vs overpaying
Let's look at another example. If Tom were to pay the £200 per month (from the example above) into a savings account, how much could he make over a year?
Well, assuming he didn't want to tie up his money for more than this timeframe, the best account for Tom would be a regular saver, as their rates are slightly more competitive. The Barclays Bank monthly saver currently pays 4.25%AER. Pay in £200 per month and he'd be looking at a balance of £2454.90 this time next year, having made £54.90 in interest (before tax).
Not earth shattering is it?
Now Tom has an existing 25-year, £150k, lifetime tracker mortgage with the Woolwich. It's set at 0.18% above base rate, meaning that he's currently paying 0.68%APR. (Believe it or not, this is a real deal that was available to borrowers with just 20% deposits - before the credit crunch.)
How much could Tom save in interest if he were to throw his £200 per month at the mortgage instead?
Well I gave our friends at Woolwich a ring and they worked out that in this situation Tom would actually only save a measly £7.50 over the year!
So by squirreling his money into a regular saver rather than overpaying his mortgage he could end up over £47 (before tax) better off.
Tax
But of course we need to take tax into all of this. And as Tom is a basic rate taxpayer his savings would actually earn just under £43, after tax. If he were a higher rate tax payer he'd have to pay around £10 more via his tax return. But that said, he would still make more money by saving the extra cash each month, rather than using it to overpay his mortgage. Surprising!
Of course, this is a very simplistic example, but it does emphasise the point.
So what should you or I do if we're wondering whether to save or overpay? Well, it pretty much depends on your mortgage rate. While we've always said that overpaying saves you more in the end, but that was before the base rate plummeted, dragging some tracker rates with it.
If you do have an ultra low tracker mortgage, it's therefore worth giving your lender a call to see how much interest you would save over a year by overpaying. Compare that to how much you could make by saving the cash (use this savings calculator to help) and you may just be surprised.
But if you decide to save the cash instead, make sure you leave it untouched if you can. That way when interest rates go up (as they will) you'll be able to use it to overpay your mortgage - and you're a winner either way.
Search for a better mortgage at lovemoney.com.
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