With housing costs eating up an increasing amount of the financial pie for many homeowners, the idea of paying down a mortgage more quickly can seem appealing. For people in the right situations, overpaying their mortgage has several advantages, including:
Become mortgage-free more quickly: Over time, extra mortgage payments can reduce your principal amount and lower your interest costs, accelerating the time it takes to pay off your mortgage.
Reduce your overall interest costs: Your interest charges are calculated based on the amount of the remaining principal. By reducing your principal, you can reduce your overall interest costs.
Increase your home equity sooner: As your principal is reduced, your loan-to-value (LTV) increases, giving you greater access to your home equity at more competitive interest rates.
Provides more flexibility: With most lenders, you can make overpayments on your schedule, giving you more flexibility in managing your cash flow.
How Does a Mortgage Overpayment Work?
When you make a mortgage overpayment, you voluntarily pay more than the monthly payment on your loan schedule. With many lenders, you can indicate whether you want your overpayment to be applied to interest or principal. By applying the overpayment to your principal, you can reduce the amount of interest calculated on each month’s principal balance. The more quickly your principal balance is reduced, the faster your interest costs will fall. Over 20 to 30 years, you can save thousands of dollars in interest costs.
Lenders have different requirements and restrictions for mortgage overpayments. You need to check with your lender on what they allow and whether they have a limit on how much you can overpay each year.
When Making Mortgage Overpayments Might Make Sense
Paying down a mortgage more quickly may seem like a good strategy, but it depends on your situation. For some, allocating more cash flow to their mortgage may not be the best use of their money. For example, until recently, mortgage rates have remained relatively low, below 5%. By reducing your interest costs, your effective mortgage rate becomes the return on your investment—say 4%. However, if you could instead invest your money in the stock market and earn 8%, it may be a better use of your money.
However, if you are properly situated financially, overpaying your mortgage to reduce your interest costs could be the best use of your money. If your financial situation falls within the following parameters, making mortgage overpayments might make sense:
You’ve Paid off Your High-Interest Debt
If you have “bad” high-interest debt, reallocating cash flow to your “good “lower-interest mortgage debt will keep the bad debt hanging around, which is not a smart financial move. When you pay off all your high-interest debt first, you clear the way for going after your mortgage.
You Have Set Up and Emergency Fund
When you make overpayments to your mortgage, that money is locked up. You can’t access it unless you take out an equity loan. Until you have set aside sufficient funds in an emergency account to cover at least six months of living expenses, overpaying your mortgage is not the best use of your funds.
You Can Afford to Make Overpayments
It’s not uncommon for borrowers who come into extra cash—such as a raise, bonus, tax refund, or some other windfall—to opt for making mortgage overpayments. That makes sense if it allows you to keep your overall spending within your budget. However, making mortgage overpayments should not come at the expense of other important financial goals, such as saving for retirement or your kids’ college education. Some lenders allow for flexible overpayments, so you can make them as your spending plan allows.
You Know What You Want to Achieve
The primary reason for making mortgage overpayments is to reduce your interest costs and perhaps shorten the term of the mortgage. But a lot depends on how you go about it. If trimming your mortgage term is your goal, you can ask your lender to keep your regular monthly payments the same with your overpayments applied on top.
If your goal is to reduce your monthly interest costs, you can ask your lender to reduce the monthly payments according to the decreasing loan amount, thus keeping the same mortgage term.
Keep in mind that lenders have varying terms, limits, and restrictions that dictate what options are available and how your overpayments may be applied. Typically, the restrictions on variable-rate loans are looser than on fixed-rate loans.
Should You Overpay Your Mortgage Payment?
There’s a lot to consider in determining whether making mortgage overpayments is a smart strategy for you. It is best considered in light of your overall financial plan to ensure it doesn’t impede your progress towards your most important goals. It would be worthwhile to consult with your financial advisor, who can help you determine your best overall strategy.
You should also consult with your lender before starting overpayments. It’s essential to understand their terms and restrictions and talk with them about what you want to achieve.
