As a property owner, you know a mortgage is a substantial financial commitment. There are various factors to consider before getting a mortgage. Not to mention that it is challenging to pay off your mortgage. Therefore, it is important to know that whether it is better to overpay on your mortgage or reduce your term. This guide will cover the difference between the two and much more.
First, let’s discuss the criteria for getting a mortgage in the UK. Then, we can discuss the advantages and disadvantages of each.
Who Can Obtain a Mortgage?
In the UK, no legal restrictions apply to any adults who are getting a mortgage. You can take out mortgages in the UK even if you are a non-resident. However, the terms will vary according to your lender.
Although each building society or bank has its own unique requirements, the key factors are the following:
You pay off home loans over a long period. Thus, older age groups find it more challenging to take out a mortgage.
Usually, building societies and banks do not reject older applicants. Yet, they are likely to ask for a larger initial deposit. Furthermore, they will limit the amount of time for making the mortgage repayment.
Job Security and Income
When offering mortgages, lenders must confirm that you can make the repayments. They need to calculate the risks of granting you a mortgage. As a result, freelancers and self-employed workers are at a disadvantage.
You must provide evidence of earnings. The amount the lender thinks you can pay back determines the amount you can borrow.
To determine whether you qualify for a mortgage, they will check your credit history. It is the same as with other forms of credit and loans.
Lenders are reluctant to grant you a mortgage if you have a low credit score or bad credit. In this case, the best solution is to try to boost your score. You can do so by making sure you are listed on the electoral register and paying off any outstanding debts.
What Does it Mean to Overpay Your Mortgage?
When you overpay your mortgage, you pay an additional amount every month along with your agreed upon loan repayment amount. You can choose the amount you can afford to pay if your lender allows you to make these overpayments. Please make sure they are within the imposed limits of the lender. Moreover, it is not compulsory to overpay each month. You can do so whenever you want to.
Depending on how much your lender will allow you to overpay and how much you can afford, the extra payment can range from £50 up to £1,000.
Nevertheless, most lenders set a maximum limit on how much you can overpay per year.
What Does it Mean to Reduce Your Mortgage Term?
You can arrange a new deal that is for a shorter period. This is called reducing your mortgage term. It is somewhat similar to making overpayments on your mortgage.
Here is an example to elaborate:
You have a mortgage which still has 20 years remaining on it. Then, you can reduce the term to 15 years.
By doing so you will pay off the mortgage sooner as the minimum monthly repayments will increase. Therefore, you can save a substantial amount of interest.
What is the Key Difference Between Reducing Your Term and Overpaying Your Mortgage?
Although there are similarities between overpaying your mortgage and reducing the term, there is a major difference. This difference lies in each option’s flexibility.
When you shorten your term, you make a formal agreement to pay a higher amount every month. This way you can repay the entirety of the mortgage over less time.
You will gain more flexibility with overpaying your mortgage. The reason for this is that if you need to you can stop making repayments and start them again later.
With overpaying, there is more flexibility, as you could decide to stop making overpayments if you need to and start them up again in the future.
In case there is a change in your financial situation, you may face difficulty in affording the higher contractual amount. Thus, you may consider going back to repaying the minimum amount instead.
Do not worry as you still have the option to make repayments over the original length of your term. Hence, it gives you flexibility for any changes in the future to match your circumstances.
Advantages and Disadvantages of Overpaying Your Mortgage
Although it may seem like a good idea to make overpayments on your mortgage, you should still consider the following benefits and drawbacks.
Following are the advantages of overpaying your mortgage:
Reduce Both Your Debt and Interest
By overpaying your mortgage, you can cut down your debt and get one step closer to achieving your goal of living mortgage-free. Undoubtedly, this is the most obvious advantage. A less obvious benefit is that you can reduce the amount of interest you owe as well.
Let us look at an example to clarify:
A total of £150,000 remains on your 20-year mortgage. The interest rate on which is 6%. You decide to overpay a lump sum of 10%, which is £15,000. As a result, you can pay off your mortgage early by a huge margin of two years and seven months. Not only this, but you will end up saving £29,600 in interest.
In comparison to what will get in interest from a savings account, you can save money by overpaying your mortgage.
Let us suppose that you decide to place the £15,000 in any easy access savings account that pays 4% interest. Then, you will receive £600 on it a year. As a result, the amount you saved in interest by overpaying your mortgage becomes more appealing.
Gain Access to Better Deals
You can cut your loan-to-value (LTV) by making overpayments on your mortgage. Which is the proportion of the price of your property that your mortgage cover.
If the value of your property increases and you can pay more of your mortgage off, LTV will decrease.
What is the benefit of lowering your LTV? Well, lenders decide which deals to offer you according to this figure. The more you decrease your LTV, the lower the interest rates you will gain access to.
Therefore, overpaying your mortgage can lead to you getting an even less expensive deal when you decide to remortgage.
Following are the drawbacks of overpaying your mortgage:
You Can Get Fined
An initial tie-in period exists with most fixed-rate mortgage. During this time, you cannot leave the deal, otherwise you will end up paying a fee.
Likewise, when you make overpayments on your mortgage, it is possible to get fined.
These fees are called Early Repayment Charges (ERC). Usually, they range between 1% and 5% of the balance.
Suppose you have a £150,000 mortgage. Then you will pay a £1,500 ERC if it is 1%.
Whereas a £50,000 mortgage equals to a £500 ERC. Which is not much of a dent in your pocket. Therefore, if you can reduce the balance and the interest substantially, it is worth it.
Typically, there is a margin. A lot of lenders allow you to make overpayments during the tie-in period of approximately 10% a year. This you can do so through monthly overpayments or chunks. Make sure to check the details of your mortgage before you overpay.
Loss of Access to Cash
It is challenging to wipe off your mortgage debt. However, you should always keep some emergency cash ready. You never know what is around the corner.
That is why it is better to have at least there to six months’ worth of pay in hand. After tax, of course. Nevertheless, the ideal amount is 12 months’ pay.
There are plenty of reasons you may need it. For example, to cover your living costs if you lose your job or do unexpected house repairs.
However, when you have a flexible mortgage, this does not always apply, such as current account or offset one.
In case you overpay, you will not run out of money as these options allow you to borrow money back.
|Reduce both debt and interest
|Access better deals
|Lose access to cash
Advantages and Disadvantages of Reducing Your Mortgage Term
Even if seems like a good idea to reduce your mortgage term, you should still consider the following benefits and drawbacks.
Following are the advantages of reducing your term:
Possibly Save More Money
Potentially, you can save more money as the interest you are paying is lower over the term.
Moreover, you are probably going to continue making the higher payments because of the formal agreement.
On the other hand, you might not want to overpay for a few months when it comes to overpaying a mortgage. Instead, you may wish to pay for something else.
Payments Remain Consistent
Financial planning and budgeting are easier when you reduce your term. This is because the payments will remain consistent, and you know the amount you owe every month.
Not sticking to your planned schedule is a possibility when overpaying your mortgage. This means you will take the same time to pay it off.
Following are the disadvantages of reducing your term:
Naturally, your circumstance can change unexpectedly. It is possible to get terminated from your job, become ill, or go through divorce. This can affect your ability to pay your mortgage. Suppose you commit to making a higher mortgage payment. In case your income is reduced, you will find it difficult to keep making the repayments.
If you make a formal agreement to make higher payments every month, your daily life has minimal wiggle-room.
Therefore, you will find it difficult to afford luxuries. It will become less likely to buy non-essential items or go on spontaneous trips.
There is less flexibility on what you can spend because of your mortgage commitment. You must work with a strict budget every month.
|Save more money
Is it Better to Overpay Mortgage or Reduce Term?
When comparing both, there is no right or wrong choice. Both options have their own benefits and drawbacks.
Various factors such as limitations on overpayment, interest rates, and other fees determine the amount you can save. Also, the type of mortgage you take out matters.
With a fixed rate mortgage, you have consistency. However, you can end up with a much higher interest rate if you have a variable rate mortgage.
So, is a fixed rate mortgage preferable over a variable rate mortgage?
When you agree to a shorter term, a rise in interest rate can lead to difficulty in making repayments.
If you opt to reduce your mortgage term, you face bigger risks. This is because there is a lack of flexibility. Therefore, you must consider the consequences in case your income decreases because of any reason.
For those who work in an industry that is booming and have job security, it is more affordable making repayments for the shorter term.
By reducing the term of your mortgage, you can typically save more money. The reason is that you are obligated by contract to lower the interest rate faster than if you had a longer term.
You need to decide whether you want more flexibility in when and how you pay or want more savings.
If you can manage to overpay your mortgage regularly, you can still save on interest significantly.
Therefore, whether to reduce your term or overpay your mortgage depends on your preference and circumstances.
To summarise, both reducing your term and overpaying your mortgage are options worth considering. Your personal circumstances determine whether one of these is beneficial for you. Please make sure to consider the advantages and drawbacks of both before you decide. By choosing the right one, you can save a lot of money and remain stress-free. Furthermore, it is crucial to know the details of your mortgage before you make any overpayment. You should know if there are any limitations set by your lender.