Do you want your mortgage to be flexible?
Before you make an offer, you will need to discuss the type of mortgage – fixed or variable.
The next question is do you want a mortgage that is more flexible? This means getting functions that allow you to increase or decrease what you repay — and overpaying is far more important than any other type of flexibility.
Can you overpay?
The most popular flexible feature is the ability to overpay, which just means paying back more than you need to — whether that’s each month or just shoving a lump sum at your mortgage from time to time. This can result in clearing the debt substantially quicker, so you pay less interest overall.
The impact of this can be huge.
Monthly payment: Total amount repaid:
£150,000 over 25 years at 5% £880
This means you paid £113,000 in interest. If you decided to, and were allowed to, overpay by £100 a month, you’d repay the mortgage 4 years and 7 months quicker, saving £23,350 in interest.
Luckily, many standard mortgages allow you to make some form of overpayment, so ask. This means you don’t always need something special (as special usually costs more).
However, they restrict the amount of money you can overpay — typically 10% of the outstanding mortgage per year or a fixed maximum amount each month (do more and there are harsh penalties).
Timing your overpayment
Mortgage companies calculate how much interest you owe on the debt at different times — the vast majority do it daily, a few quarterly or yearly. You need to know how yours works so you can time your extra payments.
With daily interest the timing doesn’t matter, you benefit the next day, but it makes a huge difference if interest is charged annually — and middling if it’s monthly.
This is because mortgage overpayments will only count to reduce the interest you pay AFTER the calculation is made. Put it in at the wrong time and you’ll miss out.
Say the amount you’ll be paying in interest is worked out on 31 December, then you need to make sure you pay the extra in before Christmas. Leave it until January and you lose the benefit of overpaying. You’ll still be charged interest as if you hadn’t made the overpayment until next 31 December.
Why overpaying pays so well
Money in savings usually earns far less than the interest on your mortgage costs you. So it’s worth doing some simple maths.
Imagine you owed £10,000 on your mortgage charging 5% and had the same in savings earning 2%. The mortgage debt costs you £500 in interest a year, while you only gain £200 on your savings — and that’s before any tax — making you at least £300 a year better off using your savings to overpay the mortgage.
So it seems it’s a no-brainer to use your spare cash to pay down your mortgage quicker. But there are a few spanners in the works.
Are you allowed to overpay? Few mortgages allow unlimited overpayments, but most at least allow 10% of the outstanding debt or £10,000 per year, so check. To get unlimited overpayments, your interest rate will usually be higher.
Do you have other debts? A crucial rule of debt repayment is: clear the most expensive debts first and by that, I mean the highest interest rates.
If you’ve credit cards and other personal loans they’re likely to have an even higher interest rate than your mortgage (unless you’re a rate tart using 0% credit cards).
Do you have a cash emergency fund? Unless you’ve a very flexible mortgage (more later), once you use money to overpay you can’t get it back. That’s a real problem if you have an emergency and need it later.
So be slightly cautious with your overpayments, don’t do it to the brink. If you then lost your job and couldn’t make the normal repayments, the fact you’d overpaid in the past won’t stop you being in arrears.
This is why I suggest you should always keep an emergency fund that will tide you over for three to six months.
Does it have a ‘borrow back’ facility?
If you’re overpaying, a few mortgages will allow you to get the overpayments back if needed — though they don’t always shout about it, making it a hidden bonus.
If it does, then you can effectively use your mortgage as a high interest savings account. By leaving money in it temporarily, the net effect is the same as earning interest tax-free at the mortgage rate — very few savings accounts will beat that. However, if it’s at a much higher rate, the increased cost on your debt may outweigh the savings gain.
Can you take payment holidays?
Here, the lender will allow you to simply stop paying it when you want. Yet be careful. Lenders don’t let you play hooky from the goodness of their hearts.
You’ll pay for it as the interest continues to be added to your loan and you won’t be clearing anything. Typically, borrowers taking a ‘holiday’ arrange to miss one or two payments, and their monthly payments are recalculated to spread the cost of the missed payments over the rest of the life of your loan — in other words, it’ll go up.
Some lenders insist you have overpaid before you can take a holiday. There could also be
an extra penalty or administration charge on top. You can’t just decide to take a payment holiday because your lender allows it. You have to arrange it with it first — if you don’t, it will impact your credit file and look like you’ve missed payments willy-nilly. Some lenders may still put it on your credit file, so be careful.
Something a bit different — offsetting
So far, the focus has been on mortgages that are variations on a simple theme. You borrow a set amount of money, you pay back a certain amount every month, and your debt is the amount you borrowed minus the repayments you’ve made. So far, so straightforward.
However, for ultimate flexibility there is a type of mortgage specifically designed to allow you to use it as a place to put your savings. These still come in variable or fixed deals as described above, but with a twist…
An offset keeps your mortgage and savings in separate pots with the same bank or building society. But the big difference is your cash is used to reduce — or ‘offset’ — your mortgage.
So, if you’ve a mortgage of £150,000 and savings of £15,000, then you only pay interest on the difference of £135,000.
You still make the standard payment every month, but your savings act as an overpayment, wiping out more of the interest every month, helping to clear the mortgage early. And as we showed earlier, the quicker you pay it off, the less it costs you overall. The best point is your savings can still be withdrawn whenever you want with no problem (but obviously it then no longer offsets your mortgage debt).
The effective savings rate is huge…
The mortgage rate is likely to be higher than what you’d earn in a savings account, so you’re best off paying less interest on the mortgage. Using an offset to reduce a mortgage with interest at 5% means you’d need a normal savings account paying 5% to beat it.
If you’re one of the few that still pays tax on your savings (ie, you earn interest over your personal savings allowance of £1,000/year for basic-rate taxpayers or £500/year for higher- rate taxpayers, or are a top-rate taxpayer), then you’d need a savings account paying even higher interest to beat your offset.
Is it worth it?
Many people get very excited by the idea of offset, but hold your horses. The problem is offsets are usually at a higher rate than standard mortgages.
Think about it. If you’ve a £200,000 mortgage, while getting a better rate on £20,000 of savings is nice, you don’t want to pay a worse rate on the remaining £180,000 debt. So in the main, unless the offset is really cheap, only those who’ll be offsetting a substantial amount of savings should bother.
Even then, you could just get a smaller normal mortgage and borrow less or overpay.
Current account mortgages
Here, as it says on the tin, your mortgage is combined with your current account, so you’ve one balance. This type of mortgage used to be far more common than it is now.
So if you have £2,000 in your current account and a mortgage of £90,000, then you are effectively £88,000 overdrawn. The debt is smallest just after your salary is paid in, and it then creeps up throughout the month as you spend your salary.
You make a standard payment every month which is designed to clear your mortgage over the term you have chosen. The extra money floating around in your account is like an overpayment, which should mean you pay the loan off much more quickly.
Any extra cash savings can be added to reduce the balance further. Many people liked the idea but didn’t like constantly seeing a debt figure in their bank account.
The additional benefit of the current account element compared to an offset is often overstressed though. Unless you have big bonuses or earn and spend a huge amount each month, it’s a tiny gain compared to an offset — and the cost of these mortgages are often much more.