Is overpaying your mortgage and reducing the term a good idea?

If your dream of buying a first home has come true, being mortgage-free some day might be next on your wish list. Paying off the mortgage is one of the first things many people say they would do if they won the Lotto.

If you don’t have endless funds, however, protecting or growing the money you do have rather than paying down debt can be a wiser choice. Yes, there are a few ways to knock years off your mortgage and tens of thousands of euro off the interest bill – just consider your wider finances first.

Don’t dwell too much on paying off your mortgage early if you’re a first-time buyer, says Lorraine Cooke of Jigsaw Financial Solutions.

“First-time buyers can be very anxious and focused on overpaying the mortgage to save interest, or to have a shorter mortgage – but I would say, don’t get too caught up with the term,” says Cooke.

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Those borrowing over a shorter term will be mortgage-free faster, and will pay less interest, but their monthly repayments are going to be higher. This can impinge on their choices right now.

Going long, however – for 35 years, for example – doesn’t mean you will be stuck with your mortgage for 35 years.

The average mortgage in Ireland only lasts about five to eight years, says Cooke. Some people sell up, clearing that mortgage before taking out another. Others will switch their mortgage to another bank for a more competitive rate. You can always just shorten the term then, says Cooke.

Going too short at the outset, however, can create cash-flow pain. Take, for example, someone who fixed their mortgage three years ago at 1.95 per cent who is now rolling off that rate on to a higher 4.5 or 4.7 variable rate, says Cooke.

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This jump in repayments will be even higher if they are on a shorter term, causing potential cash-flow problems, not least as first-time buyers are more likely to be those also facing steep costs with younger families.

“I would tell first-time buyers to consider the longest term available at the outset because you can always reduce the term at any point in time with no questions asked by the lender,” says Cooke. “But if you want to increase the term, there will be questions.”

Get the basics right

Take care of some basic financial housekeeping first before considering whether to overpay your mortgage, advises Cooke. This means looking at your mortgage in the context of your overall finances, not as something that stands alone.

Firstly, do you have a three- to six-month net salary emergency fund accessible for unforeseen events? This should be prioritised over increasing your mortgage repayments.

If you lose your job, or are suddenly faced with big bills, having savings rather than having to resort to an expensive short-term loan to cope is going to be more cost effective.

Income protection insurance should be another priority, says Cooke. A serious illness that prevents you from working can have a significant impact on your ability to keep a roof over heads and bills paid.

There is tax relief on income protection premiums too, so if you are paying 40 per cent tax, relief is paid at this rate. Consider this as a priority before throwing spare cash at the mortgage.

Make sure your mortgage protection insurance is up to scratch too. If you die, the right policy will pay off the mortgage, sparing loved ones.

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Get mortgage protection insurance before switching too. You will be older than when you first borrowed and, if you have health issues, you may not get cover at all.

Switchers should also ask their provider to reassign the existing policy to the new lender.

Prioritise pension

If you’ve got those basic financial building blocks in place and still have disposable income to spare, it can be wiser to max out your pension first before overpaying the mortgage, says Cooke.

This gives you a shot at growing the money you have, rather than using it to pay down debt.

The earlier you start putting money into your pension, the longer the runway there is for your money to grow. This is because of “compounding” – if you put money in a fund last year and it made a 6 per cent return, this year you will earn interest on your original investment plus interest on the 6 per cent return you made last year. When left for long enough, an investment can grow exponentially.

That’s why prioritising pension when you are younger, above mortgage overpayments, can be a better idea.

You can get a tax rebate on pension contributions too – you won’t get that by putting the money towards the mortgage. If you are in your 30s and on the higher 40 per cent rate of income tax, for example, you will get 40 per cent of your permitted pension contribution back in a rebate.

So, if you can put €1,000 a month into your pension, it will only cost you €600 – you will get €400 back. Why not put this free money towards a mortgage overpayment?

“Having a longer mortgage term can give you a bit more flexibility and breathing space in the short term to get your pension in place,” says Cooke. “Consider taking a 35-year term, even for the first couple of years, [assuming you are young enough to qualify for it], and reduce it down then.”

“Make use of the tax efficiencies that are there,” she says. Instead of using after-tax income to pay down debt, use it to grow your wealth with a pension.

Likewise, if you come into a redundancy payment, an inheritance or a bonus payment consider making a backdated pension contribution first, says Cooke.

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Those nearing the finish line of their mortgage can be particularly keen to pay it down, says Cooke.

“They may have €80,000 outstanding on the mortgage and €20,000 in savings and be asking: ‘Should I offset that against the mortgage and clear it quicker?’,” says Cooke.

Instead, ask yourself, do I have any other commitments or objectives for the money, such as kids going to college. Look at the bigger picture rather than being so focused on the mortgage, she advises.

Always remember that, as much as it might weigh on you, your mortgage is likely the cheapest debt you will ever incur.

Overpaying

If you’ve got the basics in order and have prioritised investing in your pension, then making additional mortgage repayments is a good idea. It can save you thousands and get you mortgage free faster.

Mortgage overpayment is certainly a more attractive option than hoarding spare cash in a low-interest savings account. As a rule of thumb, if your mortgage rate is close to, or higher than, a savings rate, then it is a good idea to overpay rather than save.

“The interest savings from overpaying will most often outweigh the returns from a traditional savings account,” says Aisling McNamara or Mortgage123.ie.

“Overpaying means you will pay less interest over the lifetime of the mortgage,” says McNamara.

If you are on a variable interest rate, you can overpay by as much as you like, without penalties. For those on a fixed rate, the interest rate and repayments are fixed, though some lenders still allow you to overpay up to a limit.

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Fixed-rate customers with Avant Money, for example, can overpay 10 per cent of the balance each year, says McNamara. With Bank of Ireland, the maximum overpayment is 10 per cent of your normal monthly repayment amount, or €65, whichever is greater, she says.

Take a mortgage loan of €330,000 over 30 years at an interest rate of 3.5 per cent with monthly repayments of €1,480. Overpaying by €100 a month will see you pay off the loan four years and six months earlier, knocking about €30,500 off the cost of your mortgage.

Monthly overpayments can be stopped or started any time at your discretion too.

Switch to save

Don’t make the mistake of overpaying your mortgage if you are on an unnecessarily high interest rate – that’s money down the drain.

Switching to the cheapest available interest rate is the best way to make progress on your mortgage; otherwise, you are paying needless extra money.

There are legal and valuation costs involved in switching, but some lenders offer cashback to cover the cost. Even if they don’t, a broker will tell you if switching will still be more cost effective over time.

To really blow the socks off your mortgage, switch to that lower interest rate, but keep your monthly repayments the same. That way, you’ll reduce the term and the interest you pay and feel no extra pain.

If you do end up selling up in future, you’ll have more equity in your home and you’ll have paid much less interest too.