What are mortgage overpayments and are they worth making?

At first glance, overpaying on your mortgage reads like a no-brainer. Why wouldn’t home loan customers want to clear what’s likely to be their largest household debt as soon as they possibly can?

Dig a bit deeper, however, and things can be a little less straightforward than they first appear. Here’s what you need to know about making overpayments on your mortgage.

Which type of mortgage?

By ‘mortgage’, in this context, we’re referring to repayment mortgages, the UK’s most common form of home loan. It’s where customers pay back both capital and interest to the lender each month.

When you take out a repayment mortgage, your lender sets out what your payments will be each month in order to clear the loan at the end of the agreed term, say 25 or 30 years.

What’s a mortgage overpayment?

If you pay back more than this contractual amount, you’re effectively overpaying your mortgage.

Even if overpayments are just a small amount each month, they will compound and reduce the total amount of interest you’d be due to pay over the life of that mortgage and, in turn, shorten the term.

However, you can’t just overpay what you like when you like. It will depend on the kind of mortgage deal you have.

If it’s a lifetime tracker mortgage for example, on which the interest rate you pay can fluctuate, you may well be permitted to make unlimited overpayments. The same goes for a flexible offset mortgage or a lender’s standard variable rate mortgage (SVR) deal.

But if you are on a deal with tie-ins during which early redemption charges (ERCs) are payable if you break the contract early, penalties will apply if you overpay by more than stated limit. Examples are fixed or tracker deals of two or five years, say.

In this case, most lenders permit penalty-free overpayments of up to a maximum of 10% a year of the outstanding mortgage balance. But always check the terms with your lender before organising overpayments.

Should you overpay?

Overpaying comes with many advantages but it might not always be the best idea.

For example, if you have other debts in addition to your mortgage, the most sensible course of action is usually to tackle those with the highest interest rates first. In this instance, credit cards and personal loans may well come higher up the pecking order than a mortgage.

Even when you’re free from other debts bar the mortgage, before thinking about overpayments it’s also worth reviewing whether you have enough spare cash set aside for emergencies.

A useful rule of thumb is to have a ‘rainy day’ fund in reserve of between three and six months of your salary before turning your attention to mortgage overpayments.

How do overpayments work?

Bearing in mind the above and assuming it makes sense to overpay your home loan, there are two ways that you can make overpayments.

The first is by making use of ad hoc or occasional lump sums to pay off your home loan. For example, from an annual bonus or other cash windfall that’s come your way. The second option is by making overpayments on a regular monthly basis.

You should contact your lender in either case to arrange the overpayment.

If you decide to make regular overpayments, you can tell your lender how you would like them to be used against your loan. They could, for example:

• Reduce subsequent mortgage payments and keep the term the same

• Reduce the term of the loan and keep monthly payments the same

In most cases it makes sense to use overpayments to reduce the mortgage term. The result should be that you clear your mortgage debt ahead of the original schedule.

How much money can you save?

The following example shows why it’s worth considering making mortgage overpayments.

Let’s say you had a £200,000 repayment mortgage with 20 years left to run where the interest rate was 3%. The normal monthly payment would be £1,109.

On the assumption that you could increase your monthly repayment by £100 to £1,209, you’d be able to reduce your mortgage term by over two years to 17 years and 10 months. You’d also reduce the total amount of interest you paid by nearly £8,000.

Lump sum overpayment

Now let’s assume the same mortgage scenario, but instead you make a lump sump overpayment of £20,000, while keeping your monthly repayments the same.

In this instance, you would reduce the mortgage term by two years and seven months and shrink the total amount of interest you’d pay from £66,206 to £51,165. A saving of more than £15,000.

Combine the two options from above and you’d not only reduce your mortgage term by nearly four-and-a-half years, but you would also save over £20,000 in interest.

Additional benefits

As well as paying off the mortgage more quickly and saving significant sums in interest payments, another benefit from overpaying is that you increase the amount of equity you own in your property more speedily.

In turn, this reduces your loan-to-ratio (LTV) profile. The LTV is used by lenders to determine how much risk they’re taking on when weighing up mortgage applications. Lowering your LTV, makes you eligible for cheaper mortgage options should you choose to re-mortgage at some stage.

How to start/stop overpaying

Contact your lender to discuss overpayment options and how these can be made. And crucially, whether these are permitted penalty-free as well as any other restrictions.

Lump sum overpayments can normally be made by bank transfer. If you use internet banking, some lenders will allow you to alter your online mortgage payments accordingly. You might also be able to set up your mortgage account as a payee enabling you to make overpayments when you want.

Can you make underpayments?

When you overpay your home loan, you may require the flexibility of borrowing back your money or having the option to make underpayments in the future.

If your mortgage is fully flexible, or if it’s an offset deal, you should be able to borrow back the amount you have overpaid and also make underpayments within certain limits.

This is less likely with other types of mortgage and another factor to bear in mind before going down the overpayments route.