Sam Dunn: 'Should I use my payout to cut my home loan?’
Wednesday 10 June 2009
Question: I've had a redundancy payment of nearly £23,000 and want to use most of it to overpay on my mortgage of £134,000. Do I have to pay tax on this cash, and do you think it's wise to use it to reduce my home loan – or will I get penalised?
Answer: First, a straightforward diagnosis: you've no worries about tax on your redundancy since the taxman allows any such payout up to £30,000 to stay free of its clutches.
But there's a second, rather more complicated issue: whether to whittle down your mortgage debt – and by how much – depends on many factors, the most pertinent of these being your personal finances' status quo.
Any decision on whether to overpay your mortgage or not raises bigger questions about your overall financial health and two worries in particular: do you have other more expensive debts and are you still unemployed?
"Although reducing debt is generally a good idea, if you have other financial commitments carrying higher interest rates than your mortgage, you should consider repaying these first," says Richard Morea of broker London & Country.
When you've credit card debts costing annual interest of 18 per cent, say, and an outstanding personal loan at 11 per cent, it can make a lot more financial sense to use spare cash to pay off these pricier debts rather than your home loan at just 4.5 per cent.
And while £23,000 will seem like a lot of money, it'll be quickly eaten up by your mortgage and other bills if you've yet to sort out another job – and could leave you horribly exposed, Morea warns.
"Even if you have no other debt, you need to consider whether the benefit of overpayment is significant enough to warrant the loss of access to this money, as it could be a financial backstop if you're unfortunate enough to remain unemployed for some time."
Few mortgages allow you to claw back overpayments if you later fall into financial difficulties, so it's absolutely vital to shore up your other finances before overpaying.
But if you're confident to go ahead, you could slash your monthly repayments.
As a rule, most lenders let you overpay 10 per cent of the outstanding "capital" value of your mortgage each year – and so reduce your overall outstanding debt, interest and remaining monthly payments – without penalty, whether you overpay monthly or by lump sum.
It's become an increasingly popular move as a rock-bottom Bank base interest rate (kept at 0.5 per cent last week) has seen tracker and variable-rate mortgage rates falling in sync.
In turn, borrowers willing to keep paying the same repayment before base rate slid from 5 per cent in October 2008 to 0.5 per cent in March are effectively overpaying each month; HSBC has even written to 30,000 mortgage customers encouraging them to do so.
But watch out for a nasty trap, warns Andy Montlake of broker Coreco: "Once you've double-checked that your lender lets you overpay by up to 10 per cent – and many do – see whether interest on your mortgage is calculated daily, monthly or annually."
This might seem like a small point, he adds, but it can have a big impact.
"If it is worked out annually, then you can end up paying down a sum now but not see the benefit in monthly payments until the end of the year." Worse, you'd lose out on savings interest that you could have earned elsewhere.
However, if interest is calculated daily, then you will see an almost immediate difference in repayments; if "monthly", make sure you time it in the fourth week for maximum effect.
To be sure, ask your lender to tell you the optimum time to make an overpayment.
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