Financial guru Martin Lewis has been explaining the benefits of mortgage overpayments and the potentially huge savings. Amid a monumental change in interest rates in the UK, both mortgage and savings rates are increasing. Aside from the political turmoil, the Bank of England recently indicated that interest rates could go as high as 5% by the end of 2023. So, what are the benefits of mortgage overpayments and how does it work?
Increase in mortgage interest rates
The typical mortgage should allow homeowners to make an annual overpayment equivalent to 10% of their outstanding mortgage balance without charges. While this may seem relatively small, the potential cumulative interest savings over 10, 20 or even 25 years can be significant.
To put this into perspective, on a £100,000 mortgage, each 1% increase in mortgage rates equates to £600 a year in additional mortgage payments. Over the last few weeks, standard variable rate mortgages have increased by 3%, equivalent to £1,800 a year on a £100,000 mortgage. Consequently, any additional payments will bring down your outstanding capital, thereby reducing future interest payments.
Potential overpayment savings
If UK base rates rise to around 5%, this could add another 3% to standard variable mortgage rates. So, in just over a year, those with a £100,000 mortgage could see their payments increase by £3,600 per year. In the early days of a repayment mortgage, when the outstanding capital is relatively high, the interest element of each monthly repayment is at its highest. As the outstanding capital falls each month, all things being equal, the interest element decreases as the capital repayment element increases. Consequently, if you can afford overpayments, this will reduce your interest charges due to the early repayment of capital.
Is it sensible to switch savings into mortgage overpayments?
This is the crux of the matter, whether it is sensible to divert savings into mortgage overpayments. Martin Lewis used the example of a £170,000 mortgage at a fixed rate of 1.1% against a savings account rate of 2.5%. If you consider a potential £17,000 one-off annual overpayment, the figures are as follows:
Mortgage overpayment savings: £5,500
Interest on savings: £11,000
Verdict: Maintain savings
If you compare this to the current scenario and a mortgage rate of 5%, the figures are very different:
Mortgage overpayment savings: £36,000
Interest on savings: £11,000
Verdict: Switch savings to mortgage overpayment
Unfortunately, not everybody can make such a significant annual overpayment, but even £50 a month will have a long-term beneficial impact. However, you must ensure that additional repayments are used to reduce your capital instead of simply lowering your future mortgage payments.
Should you overpay your mortgage?
As many people are currently enjoying relatively low fixed-rate mortgages, with savings rates increasing, it is likely more beneficial to maintain savings. However, those with a fixed-rate mortgage ending over the next 12 months could experience a 400% increase in their mortgage interest rate. Therefore, even though savings rates have increased and are likely to rise further in the short to medium term, there could be substantial cost savings by switching savings to an annual mortgage overpayment.
InterestRate.co.uk spoke to Michelle Leyland, Director at South Yorkshire Money, who told us: “The best advice is to borrow as little as possible, over the shortest affordable term as possible. If this is not feasible, then regularly overpaying on your mortgage will save you thousands of pounds over the term. Mortgage interest is calculated daily in most cases, so small regular overpayments are usually more beneficial than one off lump sum payments. Check your overpayment limit, (usually 10%) as any penalty may potentially wipe out these efforts.”