Money mensch: Your guide to repaying the mortgage
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Should you pay off your mortgage if you have any spare cash? In previous years, overpaying has usually won out. Yet repeated slashing of UK interest rates has left many mortgages at unthinkably cheap rates. These cuts make it less attractive to repay a mortgage rather than save, as home loans are cheaper. Here’s what you should do:
Deal with other debts first
For many people, it is a question of overpaying their mortgage and putting some of their spare cash and savings towards the mortgage, rather than clearing the whole lot in one go.
Yet the most important thing to understand is that your mortgage is a debt. It may have special features, but you have to think of it as a debt like any other.
So before tackling overpaying, it is crucial to ask whether you have any other debts. That is because you should always repay the most expensive debts first; mortgages are dirt cheap compared with most credit cards or loans, so prioritise clearing them.
However, there are three exceptions to this rule:
1. Struggling to get a new mortgage deal? Clearing your existing one means you are borrowing a lower proportion of the value of your house. If that puts you in a better loan to value (LTV) threshold, it could improve the rate you get on the whole of your mortgage.
2. Student loans beat mortgages. Official Student Loans Company loans, which are usually set at the rate of inflation, will, depending on when you studied, drop to 0 per cent or -0.4 per cent (ie the loan shrinks) in September, so these easily undercut any mortgage.
3. Credit card tarts. If you have a good credit score, and consistently shift from one 0 per cent deal to another, then again you will be undercutting your mortgage so should pay that off first. That said, from this point on I will assume you have no other debts: nothing to repay ahead of the mortgage.
The mortgage rate
Take a typical scenario of someone on a fixed-rate mortgage deal. This means it won’t have changed since the base rate was cut to a historic low of 0.5 per cent. If you have £10,000 of mortgage debt at 5 per cent interest, the annual cost to you is £500. If you have £10,000 of savings, earning you 2.5 per cent after tax, the interest you accumulate would be just £250. So financial logic says that if you use £10,000 of savings to pay off £10,000 of mortgage debt, you would be £250 a year better off. Therefore the crucial rule of thumb is “if your mortgage rate is higher than the after-tax rate on your savings, do not save, pay off the mortgage”.
If it is lower, put your money in a top savings account (www.moneysavingexpert.com/topsavings) because you will earn more from saving than the mortgage is costing you.
Then be ready — if your mortgage rate jumps above the savings rate after tax — to use the cash to instantly pay off your mortgage.
Look before you leap
While the maths makes sense, sometimes there are practicalities to consider which mean it isn’t worth following.
1. Are you allowed to overpay? Some mortgages charge penalties for overpayment, most commonly if you are on a special offer, such as a fixed or capped rate. This is because lenders want you to stick with them once their cheap rate ends and then shoots up; it is not in their interest to let you pay off the mortgage more quickly.
So check what the rules are: if there is a penalty, how much is it? If there is you are generally better off saving. Yet most deals allow you to make a certain level of repayment each year without penalty, perhaps up to 10 per cent of your outstanding mortgage. If that is your situation, make the repayment up to the limit, then dump the rest in the highest-paying savings account you can.
2. Keep a cash emergency fund. Once you have used cash to pay off a mortgage, the money has gone. You cannot access it (unless you’ve a special type of flexible mortgage), so you cannot easily borrow the money back. So always keep cash aside for an emergency fund, preferably enough to meet six months’ worth of bills. Remember, just because you have overpaid, it does not mean that if at a later date you cannot meet the mortgage repayments the lender will be more forgiving.
You may also have your own reasons to keep more. Ultimately, always ensure you won’t need to borrow the money back at a high rate from elsewhere.
If both those are sorted, and the financial logic fits your situation, it is worth shoving your extra cash into overpayments. Not only will you be saving year on year, but because you owe less, your interest will not be compounding and you will pay off your mortgage at a much more accelerated rate.