If you've been wondering why your friends have been wasting their spare cash on overpaying their mortgage, here's the reason why!
Last weekend, I was asked by a friend if there would be any point to her overpaying her mortgage. A number of her friends had mentioned that they had decided to pay their spare cash into their mortgages, but hadn't explained why. From her point of view, it seemed crazy to lock her money up in a long-term loan, when she could stash it away in a high interest savings account instead.
This view was certainly common ten years ago. In those days we had to pay our lenders Standard Variable Rate fixed and discounted deals simply didn't exist and most of us were resigned to taking 25 years to pay off our biggest loans.
However, this all changed in 1995 when the flexible mortgage was introduced. This new style of mortgage (also known as the 'Australian mortgage', from where it originated) was designed to suit modern lifestyles, allowing borrowers to overpay, underpay, take payment holidays but most importantly, it calculated loan interest each day.
Daily interest calculation means that any payments you make are immediately used to make your mortgage smaller. And as you've reduced your loan, you've reduced the interest payable, too.
As a result of this, making overpayments into your mortgage made a much greater effect on the total amount of interest payable.
Imagine, for example, that Tom has a £100,000 repayment mortgage, with a 25 year term and an interest rate of 6%. Tom's monthly payments are £644, and after 25 years he will have paid back a total of £193,290.
If, however, Tom were to overpay his mortgage by £50 each month, his total payment would be reduced to £177,279, saving over £16,000 in interest and reducing his 25 year term to just over 21 years!
If Tom could take this even further, and overpay by £100 each month, his total payment would plummet to £166,251, saving over £27,000 in interest - meaning he would own his home after just over 18½ years!
Most flexible mortgage lenders allow you to make overpayments by up to 10% each year. However, if your lender doesn't allow this, there is another way to obtain the same effect.
Lessening the term of Tom's mortgage from 25 years to 21 years would increase his payments in exactly the same way as overpaying by £100 each month. And although term reduction seems a more severe way to do it, as payments are fixed, Tom should be able to arrange to increase his term again, should he need to, by simply writing to his provider.
Of course, my friend could choose to save her money instead. However, even with an account paying 5%, as a higher rate taxpayer she would only see 3%. Using that cash to attack her mortgage would be a far more effective use for the money and as an added bonus, it wouldn't be sitting in a tempting instant access account, ready for any potential shopping sprees!
So if you have any spare cash each month, with no expensive loans or credit card balances hanging over your head, why not ask your lender if your mortgage allows overpayments? You may be very pleased you did!
You can find out more, or apply for a great mortgage in our Mortgage Centre.
