Don’t shorten your mortgage term if you can overpay

Don't shorten your mortgage term if you can overpay

This morning a nice lady approached me to ask a quick question about her mortgage. She said that thankfully, her finances were in a good state and she had a cheap variable rate mortgage, so she was considering cutting her mortgage term to be able to clear the mortgage much more quickly.

On the surface this is eminently sensible. Decreasing the term means you pay it off more quickly, which means there is less time for interest to accrue, so you pay less overall.

However, while it is sensible, my question to her was: "I presume you can’t overpay the mortgage?"

She told me she could – in fact she had a mortgage with fully flexible features that allowed her to overpay and even borrow back if she wanted to without penalties.

Overpaying has the same impact as shortening the term

This left me slightly stumped because overpaying has exactly the same impact as shortening the mortgage term, but with the great advantage that you can stop doing it if you want or need to.

Here are some example numbers to prove the point…

• A 25 year 3% interest repayment mortgage on £200,000
Monthly cost: £948 | Annual cost £11,380 | Total interest over 25 years: £84,530
• Shorten that to 20 years
• Monthly cost: £1,109 | Annual cost £13,310 | Total interest over 20 years: £66,210

As you can see, shortening the term increases the monthly cost, but cuts the total interest by £18,000 – a monumental saving.

Yet she would end up with a very similar result – both in cost and in the time it takes to clear the debt – by overpaying by £160 a month or a lump sum of £2,000 each year – the difference between the cost of each mortgage. (I say similar and not exactly the same as timing issues, and when the interest is calculated, can have a small impact).

If you can overpay your mortgage (and by that I mean choose to pay a variable amount more on top of your set repayments without penalties – rather than formally changing the amount you pay), it’s worth playing with our Mortgage Overpayment Calculator, which shows the impact of single or regular overpayments.

Overpaying is far more flexible

The real key here though is that she said her mortgage is at a variable rate. That means if interest rates rise, as many predict they will, her monthly costs will increase anyway. That could make the payments of the shortened term unaffordable – and there is no guarantee if you shorten your mortgage that your provider will allow you to increase it again (this can be much more difficult to do).

This could mean mortgage arrears because of the inability to pay over the shortened period.

Yet with overpaying, you could simply stop doing so by the same amount, giving you the freedom to control payments.

Overpaying isn’t for everyone

Before you start overpaying – assuming there are no penalties (or shortening your term as the impact is similar) there are a couple of things you need to think through. The first is contrasting the benefit of it against straight savings.

The simple rule of thumb is if your mortgage rate is higher than the after tax rate you can earn on savings, it generally pays, if not – for example, for someone on a very cheap legacy mortgage – you are likely to be better off saving rather than overpaying (best tactic is to put the cash aside ready to overpay in case/when rates rise).

I’d also suggest that before dunking the cash into your mortgage, you consider building up a cash emergency fund of six months worth of bills. This way if something happens you’ve got the cash put aside – rather than locked away in a mortgage (and the fact you’ve overpaid won’t stop them putting you in arrears). For far more on this and much more help see the Should I overpay my mortgage guide.