Savings rates rapidly followed the Bank of England’s base rate tumble back at the start of the credit crisis in 2008 but the same cannot be said for mortgage rates. For those with both savings and mortgages this has led to several difficult years where savings returns have been negligible and borrowing rates have remained comparatively high. The obvious question on many borrowers’ minds has been “should I overpay on the mortgage rather than save”. On the face of it this seems to be a fairly straightforward question, the more you overpay on your mortgage, the more you save in the long term. However, there are a few pitfalls to consider before taking this approach.
How Big are the Potential Savings?
A piece of string question if ever there was one, and there is no simple answer to it. A quick check using the cbonline mortgage calculator will give you some idea of what’s possible in your case. However, the basic equation is simple enough; the faster you pay off your mortgage the less interest you’ll pay. Interest on a mortgage of £150,000 at a rate of around 5% for twenty five years will work out as about 60% more on top of the original amount borrowed (or somewhere around £100,000). The fewer years you take to pay off the mortgage the less interest is owed and therefore big savings, not to mention the freedom from a mortgage, are a real possibility.
Finding the Right Balance and the Right Products
The first thing to check before closing the savings account and paying off a lump on the mortgage, or transferring your monthly savings payments to your mortgage, is the rate you’re actually getting on your savings. While mortgage rates are generally higher than savings, there are ways to reverse this situation. If, at first glance, you receive a lower interest rate on your savings than you’re paying on your mortgage then the temptation to switch is probably pretty high. However, shopping around to find better savings rates may be the more sensible option. In the last few years lower rates on mortgages have appeared (thanks to the Funding for Lending Scheme). This scheme focussed on mortgage lending, giving banks access to funds at low costs, a saving they passed on in the form of low interest rates for their customers. This scheme is now being focussed on business lending and the lower mortgage rates will inevitably begin to rise, however, they are out there still and rates as low as 1.5%-2.5% are still available for those with a lower LTV ratio. If you are a re-mortgager with 60% LTV, taking advantage of these rates now, preferably on a fixed term deal, may make better sense than investing your savings in your mortgage.
Most mortgages feature an overpayment charge or penalty – especially if you are in a fixed rate period or have a special deal in place. Before considering making overpayments you should check the fine print and see what, if any, penalties apply. Most banks have a 10% threshold for overpayments annually, which makes it feasible for most customers to benefit from overpaying up to this amount. However, be clear on the policies that apply to your mortgage as any gains made from overpayments may be negated by charges if they apply. If you’re planning on re-mortgaging to a better rate while they are still available also check you’re not tied in or subject to early repayment charges on your existing mortgage as this, again, could negate any financial benefit of switching.
Major Disasters and Credit Card Bills
Two other points need to be considered before considering diverting savings to your mortgage. Other debts and emergency cash are big factors in the decision. Most loans (credit cards in particular) will have a higher rate of interest than your mortgage. You should clear these debts first as, although they are likely to be for smaller amounts, the interest payments add up over time. Using savings to clear these first will save you money in the short term, and then move onto mortgage overpayments. Emergencies can happen to the best of us and come in many forms; from an unexpected redundancy to a broken down boiler; having an emergency fund available to deal with these should be a priority. Most experts recommend three to six months ready cash as a good level. If you have cleared your credit cards and are paying off extra on the mortgage when one of these emergencies presents itself, you’ll be tempted to pay using (expensive) credit cards. Ultimately this means that any savings you’ve gained by clearing debts and overpaying the mortgage could be wiped out. Having cash to pay for life’s little surprises is essential if you plan to reduce your interest payments on life’s bigger bills in the long run.