Mortgage overpayment advice

Question

I've got a mortgage in the UK with a 5 year fixed rate of 1.69% that expires in Dec 2025 and started in May 2021. I've decided to pay it as soon as possible and I'm trying to figure out what's the most efficient way to do that. Every year I'm allowed to overpay 10% of the outstanding balance with the fees for overpaying on top of the 10% being 5% in the first year, 4% in the second, etc. Given that, I'll definitely be able to save more than 10% of the outstanding balance every year, should I overpay all my savings immediately and pay the penalties or should I put my savings over 10% in a savings account and pay them after the 5year product expires?

Just doing the math, if I overpay at the start of the 2nd year, I'd be saving around 4 years of interest 1.69^4=8.15, so in theory I should save 8.15%-4%=4.15% on the extra money I overpay. Following this logic however, it seems less worth overpaying extra after that (3rd year is 1.69^3-3=1.8%, 4th year - 1.69^2-2=1.38% and 5th year - 1.69-1=0.69%) since I might be able to find a savings account/invest in a low risk index fund and get a better return. Is that a correct assumption?

Also, every time I overpay, my monthly payment is reduced, so that the original term doesn't change. With that in mind, should I overpay regularly, e.g monthly, or save and pay in a lump sum at the end of each year? I can't figure out which would reduce the outstanding balance faster.

Answer 1

The best way to analyse any given overpayment is by comparing it with the most similar possible alternative at the time.

Let's take your possible overpayment with 4 years left on the mortgage. Let's also assume you have some ISA allowance left.

For the 4 years until your mortgage fixed rate expires, you could take out a fixed rate ISA. That has exactly the same level of risk as the mortgage overpayment in that the return isn't dependent on any interest rate changes.

Searching right now I see rates of around 1.50% available. Your return on that money would be `

(1.015)^4 - 1 ~= 0.061 = 6.1%.

With the mortgage overpayment, you would lose 4% right away so your notional return is

0.96*(1.0169)^4 - 1 ~= 0.027 = 2.7%.

So if you have ISA allowance available, you have a clearly better alternative to the overpayment. That doesn't mean you should do that, maybe there's some better option than the fixed-rate ISA, but I would say you certainly shouldn't overpay.

If you don't have ISA allowance available, then you can still get a 4 year fixed rate account, but you might have to pay tax on any interest depending on a few factors like how much you earn and how much interest you get in total across all your savings. In fact it seems that the non-ISA fixed rates are significantly higher than the ISA fixed rates - currently 1.95% is available so it seems likely that even after tax you'd also be better off than the mortgage overpayment.

When you come to considering the overpayments in later years, you can do similar analyses based on the rates available at the time.