Mortgage Overpayments

This is an extension to a previous article I wrote on ‘The Benefits Of Paying Your Mortgage Off Early‘. Making overpayments on your mortgage is a great way of reducing your mortgage, consequently providing the opportunity to paying off your mortgage earlier than due. Overpayments is usually suited for those that want to reduce their mortgage balance and/or eventually pay off their mortgage, as opposed to investors that simply want to pay interest and rely on equity growth through house price increases.

What is mortgage overpayments?

Making mortgage overpayments refers to paying an optional extra amount each month to what is agreed by your lender at current. I recently paid a chunk off of my mortgage, so in theory I could have reduced my monthly mortgage payments because I would be paying interest on a lower loan amount. However, I decided to keep paying the same amount I had always been, consequently making overpayments, meaning I’m now chipping away a little more of my mortgage each month.

So let’s take a look at the math…
My mortgage balance was £155,000 on a 25yr agreement, with an interest rate of 5.59%. My monthly payments were £971.40 (repayment). I reduced my mortgage to £140,000. My monthly payments could now potentially lower to £877.39. But instead, I decided to continue paying £971.40 per month. That means I’m overpaying by £94.01 per month (£971.40 – £877.39). So, how much am I effectively saving? Well, I’m knocking off 4 years and 3 months of my mortgage which essentially means I’m saving a staggering £25,983 on interest rate payments alone over a 25yr period.

Interest-Only and Repayment Mortgages

You can make overpayments for both repayment and interest-only mortgages, so it doesn’t matter what type of mortgage you currently have. I’ve explained how making overpayments for repayment mortgages work, by using the example of my current situation. There’s no difference in theory when it comes to making overpayments with interest-only mortgages. A lot of people usually get interest-only mortgages because it means monthly payments will be significantly lower. The usual scenario is that a borrower can afford the interest on a property, but no more than that. However, the main issue with interest-only mortgages is that you only pay the interest on the loan, so you don’t actually reduce the mortgage balance; that’s not a very warming thought for a borrower that wants to eventually pay off their mortgage. If overpayments were made on an interest-only mortgage, the mortgage balance would be reduced per mortgage payment, and eventually the amount of interest paid would lower, meaning lower mortgage payments. ‘Lower mortgage payments’ equaling to ‘affordable’

Let me show you a quick example in real terms…
I have a mortgage of £155,000 on a 25yr agreement with a interest rate of 5.59%. If I was on an interest-only policy, my monthly interest payments would be £722.04. As mentioned, I’m not reducing my mortgage this way, I’m just surviving. If I decide I can afford to pay £800 per month, I would be making overpayments of £77.96 per month. Over a period of time my mortgage balance would reduce, so the amount of interest I pay would reduce; eventually I could be in a position where I can afford to switch to a repayment policy where I can clear my debt.

Advantages of making overpayments

I’ve already covered the primary benefit, which is the huge potential savings. The second advantage of making overpayments is that they’re usually flexible. For example, if you decide you want to stop making overpayments, perhaps due to unforeseen financial difficulties, you can do so. Thirdly, as also mentioned, over a period of time, it makes it more financially affordable for a borrower to switch from an interest-only policy to a repayment policy.

Difference between repayment and overpayments on an interest-only policy

In theory, making overpayments on an interest-only mortgage is pretty much a repayment mortgage. But what’s the difference between the two? Well, there is no major difference. The only element that separates the two methods is that with a repayment mortgage you HAVE to repay some of your mortgage per month along with paying the interest, and making overpayments with interest-only mortgage is optional.

This actually confused me a little. If that’s the case, making overpayments on interest-only mortgages seems way more flexible. And you know what? It is. So why do people bother getting a repayment mortgage? It’s because they’re not familiar with their options. Mortgages can be complicated and overwhelming.

Extra Notes
  • While overpayments seem like a good idea on paper, it essentially depends on the terms and conditions of an individual policy. Read the small print, my amigos!
  • Some mortgage policies cap the amount of overpayments you can make- find out your limit.
  • Some mortgage policies may not allow you to make overpayments at all, or there may be a certain period from when you can start making overpayments
  • Some mortgage polices penalise you for making overpayments
  • Even the smallest amount of payments can make huge differences in the long run
  • If you’re unsure of your options, ask your mortgage lender or talk to a good mortgage broker

12 Comments - join the conversation...

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CautiousFTB2007-12-29 19:07:16

So are you saying that with an interest only mortgage overpayments reduce both the capital and the monthly repayments of the interest?

I'm quite confused by this as I have been reading the details of a key facts mortgage illustration for a interest only mortgage and have noticed under the overpayments section, that it states 'Your monthly repayment will remain the same'.

How can this be? Surely they can not charge you interest on an amount that doesn't exist after you have paid of a lump sum?

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The Landlord Avatar
The Landlord2007-12-29 19:29:24

Hey,

Overpayments on an interest-only mortgage will reduce the loan balance. The more you reduce, the less interest you will pay.

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Kate2009-03-18 21:16:16

We have roughly half our mortgage interest only (with an endowment which will hopefully repay at least some of it in the end!)and half repayment. They both have 14 years left to run. We are in a position to overpay but are unsure whether it makes any difference to overpay the interest only part or the repayment part? Does anyone know whether thre is a difference?

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Jools2009-03-19 16:42:03

You really need to speak with an IFA aboiut this. I would be inclined to make overpayments on the capital as opposed to the interest as you are actually paying off some of the balance of a property that you will eventually own.

Complex field that needs specialist advice me thinks!

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Kelvin2009-03-23 11:06:10

I am a little bit confused.
In the example above is gives how much you need to over pay, but it doesn't say how long for.

Is it for the remaining term? Is it one year that will get you those savings? How does it work?

5
The Landlord Avatar
The Landlord2009-03-23 11:13:56

Hey Kelvin,

That's how much you'll save over the period of the remaining term.

The calculation is a little complicated, because each year the amount you pay on interest changes, as you're reducing the amount you're paying interest on.

The beauty about overpayments is that they're flexable. You don't have to make overpayments if you don't want to.

Perhaps this mortgage overpayment calculator maybe more uselful..

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timmy2010-01-27 15:08:43

We owe £50k on a interst only mortgage,we have 20 months left on on 5yr fixed rate @ 5.18%, i can now afford to make overpaymets of £500 per month, would you do this or save as we have been into ISA's

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Helen2010-05-19 07:46:02

Does anyone know how can I weigh up the potential benefit of paying off the interest only mortgage, against losing the allowable deduction of interest payments from rental income for tax purposes? In other words is it better to keep my capital earning interest in an another account while still paying interest on the mortgage in order to get the taxable allowance?

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Lisa2010-09-08 11:46:42

I have an Interest Only mortgage of £101000. I am currently on fixed rate which is due to expire at end of September 2010. The payment will go from approx 500 to 200 per month. If I continue to pay 500 per month. What approx will I owe at end of first year, I will be overpaying approx 300 per month = 3600. So would I in effect only owe 97400 the next year? As it is interest only do I start gaing on the first month following the overpayment?

Any advice as I dont want to overpay 3600 if I am only going to be 3000 better off?

Thanks

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Gilly2011-09-01 14:31:08

If I pay off my interest only mortgage earlier than its current 20year term, lets say 5 years earlier.
Will I be asked to re-pay the capital at the end of the original 20yr term or at the 15 year point when I have paid off the loan?
ie - will I have the remaining 5 years left on the original term in order to find the money to re-pay the capital or will I be expected to pay that back earlier also?

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Croydon862011-09-01 19:00:14

@Gilly - I am not sure if I have understood your question correctly. The loan on an interest-only mortgage does not have to paid only at the end of the term, it can be paid during the term, however your bank may have a penalty for doing so. Once this is paid though, lets say in 15 years, you no longer have to pay the loan as you would have already paid it. Is that what you are asking?

I believe interest-only mortgages are the way forward.

Firstly, it is tax deductible as Helen stated and you know exactly what you are paying in interest.

Secondly, most lenders allow you to make repayments up to 10% of the outstanding mortgage per year, so in theory you can make over payments every month, and it will be the equivalent of a repayment mortgage with the tax benefit. Or rather than make monthly payments, you can wait till the end of the year then make one lump some payment depending on how your year has gone, or just keep it in the bank/other investments. Interest-only mortgages give you more choice depending on your risk levels.

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Top Tips For Managing Your Mortgage Responsibly | Money News Now2014-03-06 06:59:38

[…] as possible because the longer a variable mortgage lasts, the more money they will make from you. Overpaying is not only tax efficient (the benefit’s equivalent to the rate you pay on the loan) but is […]

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