When there's no saving graces, why not knock years off the mortgage?

With rates so low, you can save a lot more interest by overpaying than you can earn by putting surplus cash in a deposit account. Chiara Cavaglieri reports
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The Independent Online

It's a question on many home-owners' lips: what to do with the spare cash in their pockets now rates have been slashed so dramatically that some borrowers on tracker mortgages for example, are now paying less than 1 per cent in interest. Should they simply enjoy the lower repayments and save the extra cash, or start overpaying to knock years, and possibly thousands of pounds in interest, off their mortgage?

The benefits of overpaying can be impressive. Take a £200,000 repayment mortgage with 20 years remaining and an interest rate that has fallen from 5.5 to 3.5 per cent: the monthly cost would be down from £1,375.77 to £1,159.92. But a borrower who opted to keep repayments at the original, higher level would save over £69,000 in interest and be able to clear the mortgage four years early.

With savings accounts currently offering very low rates many homeowners will also save more in interest by overpaying than they can earn by putting money away. Indeed, the number of customers making overpayments at the Co-operative bank has increased by 50 per cent in the past year. "They see it as a safe haven for any surplus money and at the same time they are reducing their commitment to their mortgage," says Terry Jordan, the Co-op's head of mortgages.

Overpaying also has important benefits in the light of falling house prices and the threat of negative equity, as borrowers can maintain or possibly increase their equity in the property – a strategy that could also prove vital when borrowers reach the end of their deal. "Not making overpayments, and letting the equity erode as house prices fall, can affect the rate you achieve on remortgaging," says Richard Morea, technical manager at broker London & Country.

However, overpayments are not without their dangers. With unemployment expected to rise sharply over the next few years, can we risk piling money into our mortgages? "It is normally better to pay off the mortgage as quickly as possible, but practically, you need to have savings put aside in case of emergency" says Mike Pendergast at independent adviser Zen Financial Services.

"Make sure that you've got at least three months of working capital as a buffer fund in the bank, in case of redundancy or temporary loss of income," adds Simon Webster, managing director of Facts & Figures, the chartered financial planner.

Additionally, borrowers might not have a free hand in the amount of extra money they put into their mortgage. For example, while standard variable rate deals usually permit unlimited overpayments, others will only allow overpayments of 10 per cent of the mortgage value each year, and some may have early repayment charges.

Homeowners also need to consider both the timing and the size of any overpayment. Nationwide, for instance, only allows an extra £500 per month without penalty. Find out when your lender calculates the interest (it is usually on a daily or monthly basis), then make sure your overpayment is made in time to be calculated immediately.

But what happens if borrowers make overpayments but then fall on hard times and find themselves struggling to meet their monthly mortgage costs? In such circumstances, lenders are unlikely to allow stretched homeowners to claw back that money However, the option may exist to take a "payment holiday" to the value of any overpayments made previously.

Homeowners on an offset mortgage can overpay into their linked savings account, with the assurance that the money can be withdrawn easily should they lose their jobs. With offset deals, interest is calculated daily, so any overpayments will reduce the interest straight away.

With mortgage rates so low, though, homeowners should make it a priority to pay off credit cards and store cards. "The first rule of financial planning is to clear your most expensive debt first," explains Mr Webster.

Some homeowners may be better off using any surplus cash to pay for accident, sickness or unemployment (ASU) insurance, which will enable them to cover their mortgage for up to 12 months in the event of being unable to work.

Mr Webster says that typical premiums for each £100 of income paid are currently available at £2.77 per month for ASU, or £2.18 if you opt for unemployment only. So to cover a monthly mortgage repayment of £500 would cost £13.85 a month.

"This recession has made us all increasingly risk averse. Loss of income through redundancy or sickness is now a real threat. In exchange for a modest premium, insurance makes it one less thing to worry about," adds Mr Webster.

However, as with any insurance policy there will be exclusions, and one of the most important is that you may not be able to make a claim if you are already under threat of redundancy, as the insurance firm might judge you to have been aware of the impending job loss. In addition, in the case of sickness, some insurance policies will only pay out if the claimant is unable to work at any job rather than simply their own occupation.

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