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Deciding whether to prioritise overpaying a mortgage or putting funds into a savings account is not an uncommon dilemma for homeowners. With interest rates, inflation trends and tax considerations to consider, the optimal choice isn’t always obvious. This article explores some of the key factors to assess so that you can make an informed decision.
Understanding the Fundamentals
What are mortgage overpayments?
Overpayment occurs when you pay more than your contracted monthly mortgage repayment. These extra payments reduce the capital outstanding and, therefore, cut the amount of interest charged over the remaining term. Lenders often cap overpayments at around 10% of the outstanding mortgage balance each year without early repayment charges applying. Any amount beyond that threshold may trigger such charges.
What are savings accounts?
A savings account is a financial product offering a fixed or variable interest rate on money that is deposited. Returns vary depending on the account type, such as easy-access, fixed-term and Cash Individual Savings Account (ISA). Savings accounts are ideal for emergency funds or short-to-medium-term financial planning, offering flexibility to withdraw funds as needed, albeit often at lower interest rates than long-term products.
Which Do I Choose?
There are several key factors to consider, including interest rates, flexibility, taxation and your personal financial goals.
Comparing Interest Rates
Mortgage rate vs savings rate: As a rule of thumb, if your mortgage rate is higher your savings rate, it is usually more rewarding to direct extra money towards mortgage overpayments. On the other hand, if you are benefitting from a high-yield savings account while locked into a low mortgage rate, it may make sense to build up the savings further.
Inflation and tax considerations: If you have a low-rate mortgage and expect inflation to be high, keeping the cheap debt while investing in savings or other assets may be worth considering. However, interest on savings above your personal allowance, usually £1,000 for basic-rate taxpayers, is taxable. Overpaying a mortgage, on the other hand, effectively offers a tax-free return equal to your reduced mortgage interest, provided that such overpayment does not trigger an early repayment charge.
Weighing Up Flexibility and Access
Cash locked away vs easy access: Money in a savings account, especially in an easy-access account or cash ISA, remains available for emergencies or planned future expenses. By contrast, once you make an overpayment on a mortgage, that cash is no longer available.
Flexible mortgages and offset accounts: Some mortgages are flexible or offer offset functionality, allowing you to overpay and access the extra payments later. Effectively, this blends savings and mortgage repayments. However, lenders typically charge a higher mortgage rate on offset deals.
When Would a Savings Account Be Better?
There are several instances in which a savings account may be a better solution:
- When the savings rate is greater than the mortgage rate: If you can get a higher post-tax rate on your savings than your mortgage interest rate, a savings account may be better than mortgage overpayments.
- When you need access to funds: If you are planning for certain costs or need a financial cushion, savings provide essential flexibility.
- If you do not have emergency funds in place yet: Before considering overpaying on your mortgage, it is wise to ensure that you have built at least three to six months of essential expenditures as savings, if possible.
Consider Your Personal Timeline
Different goals call for different strategies. If you are moving towards a remortgage or plan to sell your property soon, it may make sense to prioritise savings for moving costs or deposit top-ups. Overpaying too early could limit cash flow when needed.
Remortgaging and Loan-to-Value (LTV) Benefits
Overpaying lowers your outstanding balance, reducing your LTV ratio. This can help you secure better mortgage deals when your fixed-rate ends, which means potentially a cheaper remortgage in future.
Tax and ISA Considerations
While your personal savings allowance is usually sufficient for modest savings, if you exceed it, using a cash ISA, which shelters interest from tax, or prioritising mortgage overpayment may be more tax efficient. Furthermore, while savings interest may impact tax, reducing your mortgage is effectively “tax-free”.
How To Make Your Decision
- Check rates: Ask yourself whether you are paying more interest on your mortgage than you could earn in a savings account or cash ISA. If your mortgage rate is higher than your savings rate after tax, then overpaying may be the smarter move.
- Build emergency funds first: Before you apply extra money to reducing your mortgage balance, it is advisable to have at least three to six months of essential funds saved, if possible.
- Consider the need for flexibility: If you anticipate needing funds in the short-term, a savings account might suit your lifestyle better. If your mortgage supports re-draws or offsetting, that could give you the best of both worlds, reducing mortgage interest payments while keeping funds retrievable for when you need them. However, the mortgage rate on such a product may be high, so it is worth checking.
- Understand your mortgage terms: Most lenders allow penalty-free overpayments up to 10% of your outstanding mortgage each year. Make sure that you are not required to pay early repayment charges.
- Reassess regularly: It is advisable that every six or 12 months, or whenever a major financial change happens, you revisit your financial plan. Are you better off overpaying or has saving become the smarter move?
Conclusion
The choice between overpaying a mortgage or using a savings account depends on the post-tax financial implications and your personal goals. Generally, if your mortgage interest exceeds what you can earn net of tax on savings, overpayments are the better option. You will save more on interest payments that you would earn on savings, resulting in a higher overall return. However, if you need easy access to funds, have a low mortgage rate and can secure a higher savings or cash ISA post tax yield, then a savings account may be the sensible choice. Review your personal financial requirements carefully when making this important decision.
FAQs
Q. What is a mortgage overpayment and how does it help?
A. Overpayment on a mortgage means reducing the capital balance, which, in turn, reduces the interest payment.
Q. How much can I overpay without fees?
A. Most mortgages allow penalty-free overpayments of around 10% of the outstanding balance each year. Exceeding that may result in early repayment charges. Check your lender’s terms.
Q. Should I use a savings account first instead of overpaying?
A. A savings account is better if:
- The post-tax savings interest rate outperforms your mortgage rate.
- You need cash access for planned expenditures.
- You do not yet have an adequate emergency fund.
Q. What’s better? Overpaying or depositing in a cash ISA?
A. If there is still room in your cash ISA, using it can shelter interest from tax, making your savings more efficient, provided that the savings rate is higher than the mortgage rate. Once your ISA allowance runs out, re-visit the mortgage vs savings decision factoring in tax.
Q. Are offset or flexible mortgages worth it?
A. A flexible or offset mortgage allows you to overpay while still being able to access your funds later. Offset accounts reduce interest by netting savings against your balance. However, these products often come with higher mortgage rates, so it is worth considering this carefully.
Q. Will paying off my mortgage help me get a better future remortgage deal?
A. Overpayments lower your loan-to-value (LTV) ratio, which potentially broadens your options and often improves rates when your current deal ends.
Additional Sources:
https://www.moneysavingexpert.com/mortgages/mortgages-vs-savings/
https://hodgebank.co.uk/articles/should-i-save-money-or-overpay-my-mortgage/
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