Should I overpay my Mortgage?

A balanced view of the pros and cons of mortgage overpayments

Should I overpay my Mortgage?

With cash saving rates so low, everyone is asking: Where do I put my savings? Should I overpay the mortgage instead?

Keeping in cash is less and less attractive as inflation erodes your cash’s buying power as the years go by.

One obvious answer is to overpay your mortgage. If your mortgage interest rate is greater than your savings rate, you’d be better overpaying your mortgage.

But wait a minute!

What if I can invest my money elsewhere and beat my mortgage interest, doesn’t that mean I can earn more than my mortgage interest?

Yes, yes it does!

But investing isn’t for everyone! First, you need to figure out why you are saving & investing.

This article is information and not financial advice, read the Disclaimer.

Understand Your Goals and Timeframe

Why are you saving and investing? For retirement? To buy a bigger house in 2 years? To pay for your children’s university education? To retire early?

Figuring out your goals is vital. It becomes your beacon, your guiding star on your horizon.

It also answers your investing timeframe, as you ask yourself: ‘how long before I need access to the money?’

If the answer is ‘possibly tomorrow’ overpaying your mortgage is probably not the answer. And neither is investing.

If the answer is ‘in 10 year’, overpaying your mortgage or investing may well be the answer.

Somewhere in between depends on your situation. Investing is a longer-term option. Markets may drop 40-50% and take a decade to recover. So if you are not investing on a long term horizon of 5 to 10 years or longer you run the risk of not getting back what you invested.

Now consider you are saving for something where you need a fixed amount by a fixed date. Say a house deposit. Or university fees when your child starts university. Or a wedding deposit. You may not want to invest your capital and risk it losing value.

Overpaying may help here. If you are saving to move house, you can overpay your mortgage to increase the equity in your current property.

Overpaying your mortgage is a longer-term play, and your money can end up tied up in your property.

The money that goes towards overpaying your mortgage sometimes can’t be ‘withdrawn’. Depending on your mortgage, you may be able to ‘borrow back’ your mortgage overpayment, or use your mortgage overpayment as a reserve to take a mortgage holiday. But it’s going to take time to organise with your mortgage provider. It’s not like making a transfer on online banking. It completely depends upon your mortgage terms.

So, now you’ve figured out why and when you need the money, you can start to consider your attitude to risk.

Understand Your Risk Tolerance

Whether you hold all of your cash under your bed in a suitcase, in cash in a bank, or are all-in on Tesla should depend on your tolerance to risk.

If you invest all-in in Tesla or Bitcoin expect a rocky and volatile road. But even if you invest in a global equity index fund you can expect significant volatility. Are you happy with a 40-50% drop in the value of your investments? And are you happy that recovery may take 10 years or more, if ever?

On the other hand, if you save in cash, you can expect below-inflation returns given historic low-interest rates on cash savings. Are you happy with your money-losing purchasing power due to inflation?

These are two ends of the risk vs reward spectrum. Hold in cash ‘risk-free’ (within insured/government-guaranteed amounts) or move into riskier investments.

If you are like us, you’ll be more risk-averse. We chose to overpay the mortgage as our mortgage rate at the time was higher than our cash savings rate, and we were not comfortable having all of our net worth invested in equities. Overpaying the mortgage is a guaranteed return equal to your mortgage interest rate. The higher your mortgage rate, the better ‘returns’ (savings) you’ll make.

However, mortgage rates are historically low. You may find investing a better choice. Depending on your attitude to risk.

Emotions

Personal finance should be somewhat free of emotions. But we’re human right. We’re people, who think, who care, who get scared, who suffer from anxiety.

The ‘emotionless’ investor doesn’t exist. Ultimately, personal finance decisions are yours, and yours alone. And they’ll be driven by your way of thinking - as an intelligent but emotional individual.

We cleared our mortgage after only 6 years. We double paid our mortgage every month under a 2 year fixed deal, and then a 4 year fixed deal. When the mortgage and we reverted to the provider’s Standard Variable Rate we cleared the remainder with part of our cash savings.

We’ve been mortgage free for two years now, having achieved the milestone aged 35.

It was an emotional decision to clear our mortgage. The other-MM especially has a strong dislike of debt, having grown up in a household plagued by debt. So we both agreed to get debt-free as quickly as possible. Whilst a mortgage is ‘safe debt’ - it’s not that safe. It’s secured against your home. You can have your income slashed and you can’t make your mortgage payments, and then you lose your home.

By clearing all of our debts, including our mortgage, we now have extremely low monthly outgoings. This makes Financial Independence even easier for us - we spend so little every month.

Not only that, we have significantly less worry. We don’t need to worry about income stability to keep a roof over our head. This degree of security is invaluable to us.

This was an informed, intelligent decision. But an emotional decision. If our emotions were not taken into account, we’d have invested all our money in the markets as ‘on paper’ that’s better for returns. But that isn’t better for our situation.

It might be better for you though! Depending on your attitude to risk.

Emotions play a big part
Emotions play a big part

Maybe you take less comfort having a roof over your head for life. Maybe you take more comfort in having investments that have the chance of returns significantly above-inflation returns. That’s why personal finance is personal.

Mortgage Interest Savings

Overpaying your mortgage will reduce the amount of interest you pay throughout the mortgage. This can run into tens of thousands of pounds.

If you double pay a £130,000 25 year mortgage at 2% you’ll save over £20,000 in interest and clear your 25 mortgage in just 11 years. Try the Mortgage Overpayment Calculator to see what overpaying can do you for you. Here is an example of the interest & reduction in mortgage term by overpaying:

This is a significant saving. But depending on your attitude to risk, you may be able to beat those returns.

Opportunity Cost

Depending on your attitude to risk - you can probably beat your mortgage interest rate with investments.

Investing in a mix of bonds & equities at a somewhat conservative 4% per annum would beat almost all mortgages on the market as of September 2020.

This will compound over the years, resulting in better returns than just overpaying your mortgage. Try the Compound Interest Calculator and Mortgage Repayment Calculator with your figures to see.

Overpaying vs Investing

Assuming 4% annual returns from investing, investing will outperform overpaying your mortgage over 25 years. On paper

If you are confident in being able to achieve 4% annual returns over 25 years from investing, then you may feel more comfortable with investing. Investing with 4% returns beats overpaying a 2% mortgage by around 8% over 25 years, or 0.32% every year.

The question is whether 0.32% per annum is worth the risk of capital loss with investing in equities? Or if you are a confident investor, whether you can reliably beat that 0.32% by a significant margin?

Overpaying vs Cash Savings

If you have a very low mortgage rate, you may wish to keep your cash in the highest rate cash savings you can find.

However, finding inflation-beating cash savings is becoming increasingly difficult with tending towards 0% central bank interest rates.

If you are unable to beat inflation and your mortgage rate with your cash savings, check your mortgage terms to see if you can borrow back or use your mortgage overpayments as a mortgage holiday. If you do not need cash immediately or have a borrow back function or mortgage holiday from overpayments with your mortgage you may want to consider overpaying your mortgage instead.

Offset Mortgages

If mortgage overpayments sound too complex or you are concerned about your money being tied up in your house, you may want to consider an offset mortgage. Offset mortgages are where you can have cash savings that reduce your mortgage interest. What is a Mortgage? provides more information about offset mortgages.

Mortgage Holidays

If you overpay your mortgage, you may be able to use the overpayment as a reserve from which you can take Mortgage Holidays. If you lose your job or income, you may be able to agree to suspend mortgage payments and use the reserve. What is a Mortgage? provides more information about mortgage holidays and overpayments.

We have been mortgage free for over 12 months now, having cleared our mortgage after 6 years aged 35.

Subscribe now, follow me on Twitter @moneymagery, stick by your principles and you’ll be mortgage-free in no time.

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Sources and Attribution

  • Scream (c) mario, CC-BY