Overpay now your mortgage – and be free earlier

Low interest rates have tempted many borrowers to pay more off their mortgage each month and make long-term savings.
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The Independent Online

As savings rates continue to offer poor returns, many people are turning to mortgage overpayments as a way to save money. The potential benefits are enticing but it's essential to check the small print before you rush to overpay as early repayment penalty charges can be costly. There's also the risk of locking cash away when you may suddenly need it if you were to lose your job or were unable to work.

But first the benefits of overpaying. It cuts back on the overall interest a borrower has to pay over the term of the mortgage and actually cuts the length of the term, meaning further savings and a chance to be mortgage-free much more quickly.

Such savings have tempted many savvy homeowners to capitalise on the current record low interest rates to overpay their mortgages, according to latest figures from the Bank of England. UK property owners injected £4bn of equity into their homes in the last three months of 2009.

Most mortgage lenders will let you overpay by up to 10 per cent per annum without penalty, while Lloyds TSB has recently made the decision to allow up to 20 per cent overpayments on variable rates. Recent research conducted on behalf of Lloyds by Opinion Matters shows that around one in four consumers are already choosing to overpay their mortgage. Around half say they overpay their mortgage to reduce the term while just over a fifth say they overpay in order to pay less interest.

Michael White from the online mortgage broker Email Mortgages believes those who can afford to overpay should be doing so right now. He says: "In the current situation it is important to overpay where possible because when rates do eventually rise, and this is only a matter of time, borrowers who have overpaid and therefore have more equity in their property will be in a much better position to access more competitive mortgage deals.

"Lenders are still offering the best rates to those with greater equity and if borrowers can get their loan-to-value down below 60 per cent they will be seen as much more attractive to lenders and will be able to pick up a better rate when they come to remortgage."

Coventry Building Society has just launched two fixed-rate mortgages – Flexx Fixed – that allow borrowers to overpay as much as they like with no penalty. Meanwhile the UK's largest building society, Nationwide, will let you overpay by up to £500 a month.

Overpaying can particularly benefit first-time buyers if they have any spare cash. Hannah-Mercedes Skenfield from moneysupermarket.com says: "Flexible loans with an overpayment facility, such as HSBC's 4.49 per cent term tracker, which allow unlimited overpayments, can also be beneficial for borrowers requiring a high loan-to-value (LTV) loan but wish to make additional payments. This kind of deal will allow a first-time borrower to purchase a property with a lower deposit before house prices increase and also chip away at their LTV in readiness to remortgage to a better, lower LTV deal in future."

But borrowers should check with their own lender's rules concerning mortgage overpayments. Pay more than the lender allows and borrowers will be penalised for doing so. And the penalties can be high – even a small overpayment of the matter of a few pounds can trigger the early repayment charge which is normally charged as a percentage of the mortgage amount or can be as much as six months' interest.

Melanie Bien, director of the mortgage broker Savills Private Finance, says those constrained by the terms of their current mortgage should carefully do their calculations before jumping ship to a more flexible deal.

She says: "If your lender will not let you overpay, or you are thinking of switching to a lender who is more generous in its overpayment terms, make sure you do your sums carefully. If you have to pay an early repayment charge to exit your existing deal and end up switching to a higher mortgage rate, work out whether it is in your interests to do so in order to increase your overpayments.

"You may be better off staying put for now, overpaying by as much as you can and keeping any extra cash in a savings account ready to clear a further chunk off the mortgage when you come to remortgage instead."

Borrowers need to be aware that it is unlikely they will be able to access the money after they have overpaid, so they must be totally sure they can afford it. While in the past lenders have allowed overpayers to also underpay, take payment holidays or draw down from the amount that has been overpaid, this is now rarely the case.

Also, in the current market, securing new borrowing facilities is more difficult, and the chance of being rejected is much higher. It is wise to retain a larger amount of spare cash before overpaying the mortgage as an extra safety net, especially with the increased risk of redundancy since the onset of the credit crunch.

Ray Boulger from the broker John Charcol advises borrowers to be level-headed about their total indebtedness before rushing to overpay their mortgage, when other strategies could be more financially beneficial. He says: "The general principle should be to pay down the most expensive debt first from any spare cash or surplus savings, providing this can be done without incurring any penalty, which will obviously be the case with credit cards but probably not with an unsecured loan. Therefore, before overpaying on the mortgage, credit card debts should be paid off unless they are on a 0 per cent balance transfer rate."

Boulger points out that while most lenders now calculate interest daily a few, of which Leeds Building Society is the largest, still calculate interest annually on most of its mortgages. He says that borrowers with a daily interest mortgage will see the benefit of a lower interest charge as soon as they make an overpayment but anyone with a mortgage where interest is calculated annually needs to be careful when they overpay.

"They probably won't get any benefit until the end of the lender's financial year on small overpayments, but larger payments, say a minimum of £500 or £1,000, may be credited for interest calculation purposes at the end of the month or possibly straight away, providing certain conditions are met," he says. "Anyone with a mortgage on annual interest should check this out with their lender before deciding on the timing of any overpayments."

Michael White stresses that there are alternatives to making overpayments, especially for borrowers who are likely to need that money in the future. He says: "They are best advised to save it in an ISA, effectively keeping the cash liquid, while an ISA wrapper will ensure they do not pay tax on interest earned. Of course those with an offset mortgage have the best of both worlds in that their savings are being used to overpay plus they are able to access those savings at any time. Therefore, those serious about overpaying on a regular basis and using their savings to help should consider an offset mortgage, although they should be prepared to pay a slightly higher mortgage rate to access this type of product."

With offset mortgages, instead of earning interest on the savings, the borrower offsets the interest they would have earned against the mortgage itself. An offset mortgage makes it possible to overpay without actually overpaying any more money each month; simply by placing savings in the offset pot the borrower is technically overpaying.

While an offset mortgage offers the highest degree of flexibility, many lenders' mortgages are flexible and allow any overpayments to be used for payment holidays or to make underpayments. Conditions to be able to do this vary from lender to lender and so it is important to make sure any conditions imposed by the lender you propose using are acceptable before taking out the mortgage.

Ray Boulger says that many borrowers have this level of flexibility on the mortgage without realising it: "Some lenders, such as Alliance & Leicester, offer an extra flexible feature on some mortgages in that overpayments can also be borrowed back as a lump sum at the mortgage rate. This degree of flexibility means that one can afford to make bigger overpayments than without this facility, as effectively the overpayments can become the savings account."

One other option to overpaying for anyone who is permanently able to commit to higher regular payments is to shorten the term if on a repayment mortgage or if on interest-only switch to repayment. However, not all lenders will let you switch back to interest only if you subsequently want to reduce payments. Similarly, while all lenders will allow you to shorten the mortgage term they may not allow you to subsequently lengthen it again, even to the original term.

Overpaying: How the savings add up

The moneysupermarket.com website calculates that if an average borrower on the best standard variable rate available in November 2008 (first direct at 5.69 per cent) continued to make mortgage repayments at the same level, they would be overpaying by £105 a month, after the rate fell to 3.69 per cent. After 13 months with base rate at 0.5 per cent, such a borrower will have already saved themselves £772.32 in interest in the last 12 months alone. But over the term of the mortgage this additional payment of £105 would equal an overall saving of £14,519 in interest and would cut the mortgage term by six years and two months.

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