"Overpaying is normally a great way of reducing the cost of borrowing for your home, but it can leave you in a tricky financial situation if you find yourself needing the extra money further down the line."
The ongoing cost of living crisis will see many homeowners contemplating the future and how they can protect their finances against it. However, with so much uncertainty, the process of figuring out the best way to go about this can feel overwhelming.
When thinking about overpaying your mortgage or whether to put money into your pension, the decision should come down to what is going to give you the most money in return. Is that putting money into a pension - which can be a great tax-efficient way of investing for your future needs - or by overpaying your mortgage, which will possibly save thousands on interest?
Overpaying a pension will mean you are likely to be building more wealth over a longer period of time, as by their very nature, investments take a while to grow. Most pensions will grow between 2-3% a year which might not seem like much, but over a long period and with a larger amount in the pot, this does add up.
However, with interest rates for mortgages currently much higher than that, this could mean it’s better to overpay your mortgage than a pension.
The mechanics of overpayment
Overpaying can be very beneficial. It lowers the amount you are paying in interest (and thus the cost of the loan) and increases the equity you own, making future remortgages potentially cheaper as you will be borrowing less.
There are a few key things for you to consider. First, it’s important to know how much your mortgage provider will allow you to overpay, if at all. Some lenders will have no limits, however, others might have a set amount you are allowed to pay off extra each year.
You also need to know how much you can afford to overpay. It’s always important to think about the longer term as well as the short term. Just because you overpay one month, it doesn’t mean you can underpay in the following months. So, thinking longer term on if you can afford to overpay is vital, as you don’t want to be short for future months.
Once you have decided you can afford to, you should then consider whether you overpay monthly (for example, paying an extra £100 on your monthly fee) or as a one-off through a lump sum. Overpaying each month, even if it is as little as £100, will likely save you money in the long run. It also offers you more flexibility if you come into a situation where you need that extra cash - you can simply lower your payment to the pre-agreed fee.
Possible pitfalls
Paying in one large lump sum will likely help you clear the mortgage faster and will certainly reduce the interest you are paying. However, if you suddenly need that extra money back, you won’t be able to withdraw it from the mortgage, so only do this if you know you won’t need that money.
Overpaying is normally a great way of reducing the cost of borrowing for your home, but it can leave you in a tricky financial situation if you find yourself needing the extra money further down the line.
Finally, whatever your initial thoughts, always take time to think about each option carefully. It is strongly advised to talk with a financial adviser, as there is a lot to consider on both fronts, including your age, your employment status, plus details relating to tax relief that may be available on pension contributions too.
