A mortgage is usually the biggest financial outlay that you will commit to, so it is important to understand how you can keep the total loan repayment to a minimum.
As your financial circ*mstances change, you may be in a position to overpay on your mortgage or reduce the term.
Both overpaying and reducing the mortgage term can help you to save a considerable amount of money.
In this article, we review the pros and cons of the two options to help you to decide which is the right choice for you.
We also produced a comprehensive video guide on the topic:
In this article...
- What is overpaying?
- What is reducing term?
- What's the difference between overpaying and reducing your mortgage term?
- Pros and cons of overpaying your mortgage
- Pros and cons of reducing the mortgage term
- Should I overpay my mortgage or reduce the term?
- Other considerations
What is overpaying?
Overpaying your mortgage loan involves paying an extra amount each month on top of your agreed loan repayment amount.
If your lender allows you to make overpayments, you can choose how much extra you can afford to pay within their imposed limits. You are not committed to make overpayments every month, just when you want to.
The additional payment could be just £50, or it could be £1,000, depending on your affordability and how much your lender allows you to overpay.
Many lenders will apply a maximum limit on how much you are able to overpay per year.
Overpaying allows you to repay your mortgage loan faster and save on interest.
What is reducing term?
Reducing your mortgage term is similar but slightly different to overpaying your mortgage.
When you reduce the length of your mortgage term, you are arranging a new deal which is spread over less time.
For example, your mortgage could have 22 years remaining, but you decide to reduce the term to 17 years.
This would mean that your minimum monthly repayments increase and you pay the mortgage off sooner, saving a significant amount of interest.
What’s the difference between overpaying and reducing your mortgage term?
Overpaying and reducing the term are very similar but the key difference is the flexibility of each option.
Shortening your term is a formal agreement that you will pay a higher amount each month, to repay the full mortgage over a shorter period.
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.
If your financial circ*mstances change, you might not be able to afford the higher contractual amount and you may want to go back to repaying the minimum amount.
You still have the flexibility to repay your mortgage over the original length of term, so it is an option that allows for future changes to suit your circ*mstances.
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Flexibility
The main pro of overpaying is that you have the choice to stop overpaying whenever you want to.
You can change the amount you overpay to suit your monthly affordability as long as its within the lender’s overpaying facility.
So, if you get a pay rise, for example, you could increase the overpayment amount.
Cons
Not always an option
Not all lenders will allow you to make overpayments, so you might not have the option to overpay.
Overpayment fees
Some lenders apply a fee if you overpay, or if you overpay higher than the allowed amount, you will be charged a fee.
In this situation, you would therefore not be saving as much money as you could if you reduced the term (when calculated based on the same interest rates).
Maximum overpayment amount
With most fixed rate products, which are currently most demanded in the market, you may only be able to pay up to 10% of the outstanding amount each year, but if you could afford to pay more, a reduced term could be the better option save interest.
Due to the maximum overpayment amount, if you inherit a sum of money, you might not be able to use it to pay off your mortgage straight away.
However, there are some mortgage products, such as Tracker, Discount and Standard Variable, that tend to have no overpayment restrictions.
If you are planning to make large overpayments in a short period of time, these products may be most suitable for you.
Pros
Potentially save more
You could potentially save more money due to the lower interest being paid over the term.
As there is a formal agreement in place, you are more likely to continue making the higher payments.
Whereas, with overpaying you might be tempted to not overpay for a few months, in order to pay for something else.
Consistent payments
When you reduce the term, the payments remain consistent, and it is easier to budget and make financial plans as you know exactly how much you have to pay each month.
With overpaying, you might not stick to your planned schedule, which could mean you end up taking a similar amount of time to pay off your mortgage.
Cons
Less flexibility
Circ*mstances over your lifetime can easily change and these changes may be unpredictable.
People can be made redundant, go through a relationship breakup or become ill, which could affect the ability to make mortgage repayments.
If you have committed to making a higher mortgage payment amount, it will be harder to continue making the repayments if your income is reduced.
Less wiggle-room
When you formally agree to make higher payments each month, you have less wiggle-room in your daily life.
So, luxuries like spontaneous trips away and other non-essential purchases will be less possible.
You are working to a tighter budget each month, with less flexibility on what you are spending due to your mortgage commitment.
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Should I overpay my mortgage or reduce the term?
There is not a right or wrong answer, as both options have some positive and negative results.
The amount you can save will depend on a wide variation of factors including interest rates, any overpayment limitations and other possible fees involved in the mortgage deal.
Another important factor to consider is the type of mortgage you take out.
A fixed rate mortgage will stay consistent but if you have a variable rate mortgage, you could end up on a much higher interest rate.
If you have agreed to a shorter term, a hike in interest rate could make repayments unaffordable for you.
Choosing to reduce the term of your mortgage loan has bigger risks due to the lack of flexibility, so you should think about what would happen if your income reduced for some reason.
If you have a lot of job security and work in an industry that is thriving, you may be more confident in being able to repay your mortgage for the new, shorter term.
Generally, you can save more money by choosing to reduce the term of your mortgage, as you will be contractually obliged to reduce the interest quicker than if you have a longer term.
You have to decide whether the potential savings are worth giving up the option of more flexibility around when and how much you pay.
You can still save yourself a large amount of interest by overpaying your mortgage, as long as you do it regularly enough to make a difference.
Other considerations
Before you decide whether to reduce the term on a mortgage, you should consider whether it is the right time to do it.
Just like any other time you arrange a new mortgage deal, you should consider details such as whether you can arrange a lower mortgage deal due to reaching a better LTV (loan to value) ratio.
If you have a 60% LTV rather than 65%, then you could be eligible for a deal with a lower interest rate. Therefore, paying the mortgage over a shorter period would be more affordable than doing it at 65% LTV.
Speaking to an adviser will help you to understand the options that you have available, and they will be able to provide calculations to show you the difference between overpaying or reducing term.
They will look at your specific circ*mstances, such as income, other financial commitments, age, job security and other individual factors that will influence the suitability of each option.
Boon Brokers provides expert mortgage advice based on your specific financial circ*mstances, to ensure that you choose the best option for your short and long-term finances.
Contact our mortgage team today and we can help you to get started with your mortgage application and enable you to get onto the property ladder. Boon Brokers offers a fee-free, whole-of-market, mortgage advice and arrangement service.
Gerard BoonB.A. (Hons), CeMAP, CeRER
Gerard is a co-founder and partner of Boon Brokers. Having studied many areas of financial services at the University of Leeds, and following completion of his CeMAP and CeRER qualifications, Gerard has acquired a vast knowledge of the mortgage, insurance and equity release industry.
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