Over the last few years, interest rates have remained low, and it’s likely they will for the next few years. This leads many to consider whether they should pay off their mortgage early.
While others may be happy to keep on top of repayments and take their time. There’s no right or wrong option as they both have pros and cons.
Here’s how to decide if you should pay off your mortgage early.
What is your current mortgage type?
If you have an interest-only mortgage, then paying more each month will have no impact on your overall indebtedness.
You’ll need to save that money in a bank and make a capital repayment. It may be worth switching to a repayment mortgage, as paying extra each month will reduce your overall debt.
Pay down expensive debts
As you typically borrow over a 25 year plus period, mortgages are fairly cheap, especially when compared to other forms of debt.
While you might not be able to borrow such a large amount on a credit card, the rate will be higher. This means in percentage terms, you’ll end up paying back more.
So before you consider overpaying on your mortgage, clear any high-interest debt you have. Start with the highest interest credit card or unsecured loan and pay that off first. Then conquer the next debt and so on, until you’ve paid off all other debts.
Put money into a pension
Many consider having a mortgage-free property as the best financial plan. This isn’t always the case as the property crash of 2007 taught us.
Pensions, on the other hand, are a fantastic tax-efficient way to save because the government tops up your contributions with tax relief.
If you’re employed, the benefits could be even better. In the typical company pension scheme, your employer is likely to contribute to the scheme.
Even a small monthly employer contribution over your working life can have a massive impact on the final amount you’ll receive, thanks to the power of compounding.
If you don’t have a pension, start one today. Or if you do, it’s worth auditing it inline with your long term financial goals.
It might make better long term sense to pay more into a pension and keep paying the basic mortgage payment each month.
Buy life assurance
The moment you hear the phrase life assurance, your mind jumps to Saga or Michael Parkinson. However, having the right life assurance will enable your family to survive after you die.
The cost of buying a policy is usually a couple of pounds per month and provides peace of mind, instantly.
So if you don’t have life assurance, now is the time to consider buying.
Can you save money at a higher interest rate?
With low-interest rates, the typical saver gets a bad deal at their bank. Thankfully, many options are available beyond the high street banks which offer a superior return.
Your options include standard and share ISAs, both of which are tax efficient.
While not as tax efficient as ISAs, you could invest directly in shares or a low-cost passive index fund. Both have the potential to provide a bank beating return without much risk.
If you do invest in shares, try to make small, consistent returns each month. Do not become overconfident and start to gamble.
Growing your money this way might provide a better return than paying more off your mortgage. You might find that you can compound your money at a faster rate and be able to pay your outstanding mortgage loan off in a few years.
Build your rainy day fund
There’s one thing certain about life, a rainy day will come along before too long and you’ll need a bit of money saved. Even if you’re fantastic with money, it’s worth holding at least 3 months of living expenses in the bank.
When you survive for at least 3 months without working then you can consider paying more off your mortgage.
Will you be charged for overpaying your mortgage?
Many lenders will allow you to pay up to 10% of the remaining loan off each year without any charges or costs.
Over 10% then you might have to pay extra charges on top. If you’re unsure, then you’ll need to re-read your mortgage agreement or call your lender.
Remember any extra fees could lower the rate at which you can compound your money using say an ISA. If your money is growing at a slower rate, it’ll take you longer to pay off your mortgage.
Should I worry about tax?
Tax is a complicated subject and so it’s worth speaking to an expert before you start moving money around.
Savings and investments are on the whole taxable unless you’re using a tax shelter like an ISA. If you do have lots of savings, it’s worth seeing if you rearrange them in a more tax efficient way.
As mortgage payments aren’t taxed, it can make sense to pay off your mortgage rather than saving it.
Again it’s worth getting professional tax advice before making any decision.
Do you have a flexible or offset mortgage?
If you have a flexible mortgage, including offset mortgages, then you could be able to overpay your mortgage without any cost.
In addition to being able to overpay, if you need money quickly, then you can always draw some out without any charges.
Are there any benefits to overpaying a mortgage?
There are many benefits to paying more off your mortgage sooner. You could be able to pay off the remaining loan quicker.
It could be a great way to build a bigger deposit for your dream house or secure your finances for years to come.
When an interest rate rise does happen, you’ll be in a better place as you’ll have a smaller mortgage to pay off.
To put this into numbers, imagine you have a mortgage of £150,000 at a 5% rate with 25 years still to pay. If you paid off an extra £5,000 next year, you will effectively reduce the interest by £11,500. This means you’ll repay 18 months earlier.
Calculate you Interest rate date
After considering both sides and deciding to overpay, you need to time it right.
If your charged daily interest, then you will want to start overpaying right away.
However, if it’s calculated annually, then you need to time when to star overpaying so that it counts towards the calculation of the interest for the year.
Deciding on your best option
In the end, it boils down to the type of mortgage you have and whether it’s best to pay off other debts first and save, or start overpaying now.
If you can pay off all your others debts and compound your money at a faster rate than your mortgage, then you might be able to knock years off the term.
Another option is to invest in your future with a pension and ISAs and let the mortgage take care of itself.
Before selecting an option, it’s worth getting some tax advice and mocking up different options in excel.
Regardless of what you end up deciding, it’s worth re-evaluating every 3 to 5 years to see if your plan still aligns with your goals.