Millions of homeowners could take advantage of a savvy trick to free themselves of their mortgage years early and slash the amount of interest they pay by thousands of pounds. And now could be the perfect time to try it.
For years, savings rates were so generous that homeowners were best off putting their spare cash in a top account to make a good return and keep their money safe.
But now you could save thousands by diverting some of that loose change into your mortgage instead.
And as savings rates continue to fall and the tax net tightens, the benefit of using savings to overpay your mortgage should continue to grow.
Households are being squeezed from both ends. Banks and building societies have been rapidly slashing rates on their savings accounts.
The number paying above 4 per cent has dwindled. And while mortgage rates have trickled down, they remain inflated compared to their levels just a few years ago.
Overpayment: Homeowners can make an extra payment – on top of their monthly one – which can shorten the length of their term and reduce the total amount of interest they will pay
It means that homeowners must now pay more in costs on their home loan than they can earn in a savings account.
Savvy borrowers can use this squeeze on households to their advantage.
You’ll have to have your wits about you to ensure that the numbers stack up in your favour. Here, Money Mail explains exactly how to do it.
How does it work?
Overpaying on a mortgage simply means paying more than the agreed monthly bill.
Homeowners can make an extra payment – on top of their minimum monthly one – which can shorten the length of their loan term and reduce the total amount of interest they will pay over the years.
However, there is a fundamental rule of thumb for this nifty trick to work. It will only save you money if your mortgage rate is around the same or higher than the savings rates you can access.
If savings rates – especially on tax-efficient Isas – sit above your current mortgage rate, then you may be better off squirrelling away your spare cash.
On Monday, the average two-year fixed-rate mortgage was 4.85 per cent, while the five-year rate was 4.94 per cent, according to rate scrutineer MoneyfactsCompare.
Savings rates, on the other hand, sit well below this. Those opening a fixed-rate account can bag 3.81 per cent, and if you want easy access to your money, your savings will earn a pitiful 2.42 per cent.
The average easy-access cash Isa pays 2.60 per cent. It means that if you have some spare cash, you will save more money in the long term by funnelling it towards your mortgage.
Instead of accruing interest from saving money in an account, you will effectively ‘earn’ the mortgage rate on the amount you overpay, explains David Hollingworth of broker London & Country (L&C).
You’ll also be mortgage-free sooner as your spare cash eats away at the total amount owed more quickly.
This is even the case when compared with the return on the best-paying Isa, currently on offer with Atom Bank at 4.25 per cent.
Caitlyn Eastell, personal finance analyst at MoneyfactsCompare, says: ‘For many homeowners, spare cash has been sitting in savings accounts earning less and less interest.
‘As savings rates are expected to fade from their peaks, it may now be more cost-effective for households to use that money to make mortgage overpayments instead.
‘Overpaying offers an almost guaranteed saving, boosting home equity and, over time, potentially knocking years off the length of the loan.’
Plus, savers are increasingly being dragged into paying tax on their hard-earned cash sitting in savings accounts, if held outside of an Isa.
A basic-rate taxpayer can earn £1,000 in savings interest each tax year before tax is levied. This personal savings allowance (PSA) is £500 for higher-rate taxpayers while additional-rate taxpayers have no allowance.
If you are not saving into an Isa or don’t have any remaining PSA, you’ll need to secure a higher savings rate to offset the tax bill and get the same return as you would from overpaying your mortgage.
For example, if your mortgage rate is 4.85 per cent, you’d need to earn 6.06 per cent as a basic-rate taxpayer to get the same effective return in a savings account.
For a higher-rate taxpayer this is 8.08 per cent and for an additional rate taxpayer it is 8.82 per cent. There are no standard savings accounts (or Isas) that pay this much.
Mr Hollingworth says: ‘As interest rates drop back, savers may have to look harder to maintain returns. Overpaying a mortgage could be a better way to use spare cash to get a good return and pay off the mortgage more quickly.’
What’s the saving?
The more you overpay, the more you save on interest – and these savings can snowball.
Take a borrower with a £243,900 mortgage over 25 years at 4.85 per cent. Their monthly mortgage payment is £1,404.58.
However, if they funnelled an extra £100 a month into their mortgage, they would save £24,215 in interest across the term and would repay the home loan two years and 11 months early, L&C calculations show.
Borrowing costs: While mortgage rates have trickled down, they remain inflated compared to their levels just a few years ago
This assumes their home is worth the UK average of £271,000 and they put down a 10 per cent deposit.
A £200 monthly overpayment cuts the total interest by £42,337 and the mortgage will be repaid five years and two months early.
This trend is true for more expensive homes, too. A homeowner with a £405,000 mortgage over 25 years on a house worth £450,000 will pay £2,332.33 a month in repayments if their rate is 4.85 per cent.
However, by paying off an extra £100 a month, they can cut their total interest bill by £25,699 and pay off the loan one year and nine months early.
A £200 overpayment would save them £47,038 in interest and end the term three years and five months early.
Around one in four mortgage holders make overpayments averaging £221 per month, according to a survey last year by Barclays.
What’s the catch?
Overpayments can save you a lot of money in the long run. But you must beware of one sneaky pitfall.
Most fixed-rate mortgage deals allow borrowers to make overpayments amounting to 10 per cent of the total outstanding amount each year.
But any more than this and you may be slapped with an early repayment charge. Some are more flexible and others may be more restrictive with the amount you can overpay. Fees typically range from 1 per cent to 5 per cent.
Check with your lender how much you can overpay before being charged. You can then adjust your monthly direct debit or standing order via online banking, on the telephone or in-branch, or make a one-off payment by debit card.
If you need to return to the lower contractual monthly payment with your lender, you can. It can take up to seven working days.
If you want to pay more than that without incurring a charge, you will have to wait until your existing mortgage is up for renewal.
Once you overpay your mortgage, it’s hard to access the money again. If you suspect you may need access to cash in the near future, consider keeping your money in a savings account.
