Is overpaying on your mortgage better than saving?

As mortgage rates rise and saving interest rates remain low are you better off saving, or paying off your mortgage quicker?

For a long time, with a low Bank of England Base Rate resulting in better mortgage deals, it was considered wise for homeowners to put any additional money into savings. However, with inflation now at a 40-year high and rising mortgage costs, homeowners may now be better off paying more towards their mortgage than saving for a rainy day.

How expensive are mortgages getting?

According to Martin Lewis of Money Saving Expert, very. As recently as October 2021, homeowners with good credit ratings could fix mortgage rates at just under 1%. However, even the best fixed mortgage deals are now coming in much higher than this – with the best two-year fixed mortgage coming in at 4.95%, the best five-year deal now set at 4.62% and the best 10-year deal coming in at 4.85% as of 6 October.

Martin Lewis says this increase will make a huge dent in UK bank balances: “That 4% point-ish rise in mortgage rates equates to around £200 a month more (£2,400 a year) per £100,000 of mortgage debt,” he says.

With savings rates coming in at around 2.5% or under, it’s easy to see how for some people, paying extra on their mortgage makes more financial sense.

How did we get here?

On 22 September 2022, the Bank of England raised its Base Rate (generally just known as the interest rate) from 1.75% to 2.25% – the highest it has been in 14 years – in response to the increasing rise of inflation.

The Bank of England’s interest rate affects all interest rates – including the rates of variable mortgages – and so it was anticipated that mortgage costs would begin to rise.

However, this was compounded by what happened next.

On 23 September the former Chancellor Kwasi Kwarteng announced his mini budget and criticisms began mounting.

By Monday 26 September the Pound had hit an all-time low against the Dollar and mortgage lenders began suspending products.

Moneyfacts said that by Thursday 29 September – less than a week later – 1,621 mortgage products had been withdrawn from the market.

Though the new Chancellor Jeremy Hunt’s U-turn on much of that budget has helped stabilise the market to some extent, there’s no sign yet that interest rates will drop again any time soon and the Bank of England is due to make its next interest rate decision on 3 November.

What does overpaying on your mortgage mean?

When you take out a capital and interest mortgage, your lender will work out how much you need to pay each month to ensure the full amount, including interest, is paid up within the agreed term.

Overpaying means simply paying more than you are obligated to and this can be done in regular monthly payments (i.e., increasing your direct debit) or via occasional lump sums.

Forbes says that it’s almost always worth ensuring that when overpaying, your lender reduces the term of the mortgage and not the monthly payments. It says: “This will result in you clearing your mortgage debt ahead of schedule.”

Who should overpay on their mortgage?

If you are looking to remortgage or your current rate is going up, then with limited options available, there’s a good chance that overpaying on your mortgage is a good idea.

Martin Lewis says to look at it this way: “For example, £10,000 in savings at 2% earns £200 for the year yet use it to overpay a 3% mortgage and it reduces costs by £300 for the year. Effectively overpaying is tax-free 'saving' at the mortgage rate, so if the rate's higher than savings (after tax) it wins.”

Martin Lewis says he has one key rule he believes all homeowners should abide by: “Only overpay if your mortgage rate is higher than the rate you’d earn saving.” 

Who should not overpay on their mortgage?

If you’re still on a decent fixed rate (i.e., below 2%) mortgage, then for now you should probably put any extra money in savings or towards paying off high-interest debts.

The best saving account rates for easy access are currently around 2.5%, while if you are happy to put money away more securely then you may be able to get rates as high as 4.1% for savings accounts where you can’t touch the money for a year or more.

Things to consider before you overpay on your mortgage

• Can you afford it?
  While it may be tempting to fight back against the rising mortgage costs by paying more, only do so if you can genuinely afford to – as even if you overpay now, there’s nothing to say this will make your mortgage company any more merciful if you fall into arrears further down the line.
• Will you need to pay a fee?
  You’ll also need to find out if there are any fees for overpaying – some lenders will add fees if you go over a threshold of overpayments.
• Are there other debts you should pay off first?
  Think about if this is the best way of managing your finances – though mortgage rates are rising they are still often less than the interest rates on other loans and credit cards, so if you have other debt, consider paying that off first.

To find out whether you should shift to paying more on your mortgage, use Money Saving Expert’s mortgage overpayment calculator.

Main photo: 2017 Cast Of Thousands/Shutterstock