Should I overpay to end a fixed-rate mortgage early? [duplicate]

Question

About six years ago, UK interest rates hit the historic low of 0.5%. In keeping with all the finiancial advice at the time that this was a once in a lifetime circumstance I rushed out and got a fixed rate mortgage. For ten years. The interest rates have not increased at all that whole time, and I've lost money every single month.

The terms of this mortgage are very strict. There is a substantial penalty (£1,000 per year remaining) to get out of it. I can only overpay up to double the monthly amount of the mortgage. If I do it makes zero difference to the actual amount I will pay overall - the only result will be to end the mortgage early.

I could afford to overpay each month if I wanted to. However, to my mind this is the least logical thing to do in this situation. As I said, I've lost money on this every month. The only chance I have to make up what I've lost is if interest rates rise during the remaining term of the mortgage. It seems likely this is going to happen within the next 12 months, and it's possible there may be further rises in the remaining 3 years.

When friends and family quiz me about this, they seem amazed that I'm not overpaying. And when I explain the above, they seem unable to understand why I think overpaying is the last thing I should be doing. It's happened so many times now that I'm starting to doubt the wisdom of my decision. So - am I right not to overpay?

Answer 1

I would strongly encourage you to either find specifically where in your written contract the handling of early/over payments are defined and post it for us to help you, or that you go and visit a licensed real estate attorney.

Even at a ridiculously high price of 850 pounds per hour for a top UK law firm (and I suspect you can find a competent lawyer for 10-20% of that amount), it would cost you less than a year of prepayment penalty to get professional advice on what to do with your mortgage. A certified public accountant (CPA) might be able to advise you, as well, if that's any easier for you to find. I have the sneaking suspicion that the company representatives are not being entirely forthcoming with you, thus the need for outside advice.

Generally speaking, loans are given an interest rate per period (such as yearly APR), and you pay a percentage (the interest) of the total amount of money you owe (the principal). So if you owe 100,000 at 5% APR, you accrue 5,000 in interest that year. If you pay only the interest each year, you'll pay 50,000 in interest over 10 years - but if you pay everything off in year 8, at a minimum you'd have paid 10,000 less in interest (assuming no prepayment penalties, which you have some of those). So paying off early does not change your APR or your principal amount paid, but it should drastically reduce the interest you pay. Amortization schedules don't change that - they just keep the payments even over the scheduled full life of the loan.

Even with prepayment penalties, these are customarily billed at less than 6 months of interest (at the rate you would have payed if you kept the loan). Therefore, if you are supposedly on the hook for more than that again I highly suspect something fishy is going on - in which case you'd probably want legal representation to help you put a stop to it.

In short, something is definitely and most certainly wrong if paying off a loan years in advance - even after taking into account pre-payment penalties - costs you the same or more than paying the loan off over the full term, on schedule. This is highly abnormal, and frankly even in the US I'd consider it scandalous if it were the case. So please, do look deeper into this - something isn't right!

Answer 2

The simplest argument for overpayment is this:

Let's suppose your fixed rate mortgage has an interest rate of 4.00%.

Every £1 you can afford to overpay gives you a guaranteed effective return of 4.00% gross.

Yes your monthly mortgage payment will stay the same; however, the proportion of it that's paying off interest every month will be less, and the amount that's actually going into acquiring the bricks and mortar of your home will be greater. So in a sense your returns are "inverted" i.e. because every £1 you overpay is £1 you don't need to keep paying 4% a year to continue borrowing.

In your case this return will be locked away for a few more years, until you can remortgage the property. However, compared to some other things you could do with your excess £1s, this is a very generous and safe return that is well above the average rate of UK inflation for the past ten years.

Let's compare that to some other options for your extra £1s:

Cash savings: The most competitive rate I can currently find for instant access is 1.63% from ICICI. If you are prepared to lock your money away until March 2020, Melton Mowbray Building Society has a fixed rate bond that will pay you 2.60% gross.

On these accounts you pay income tax at your marginal rate on any interest received. For a basic rate taxpayer that's 20%. If you're a higher rate taxpayer that means 40% of this interest is deducted as tax.

In other words: assuming you pay income tax at one of these rates, to get an effective return of 4.00% on cash savings you'd have to find an account paying:

• 5.00% before basic rate tax of 20% (5.00 * 0.8 = 4.00)
• 6.67% before higher rate tax of 40% (6.67 * 0.6 = 4.00)

Cash ISAs: these accounts are tax sheltered, so the income tax equation isn't an issue. However, the best rate I can find on a 4 year fixed rate cash ISA is 2.35% from Leeds Building Society. As you can see, it's a long way below the returns you can get from overpaying.

To find returns such as that you would have to take a lot more risk with your money – for example:

Stock market investments: For example, an index fund tracking the FTSE 100 (UK-listed blue chip companies) could have given you a total return of 3.62% over the last 3 years (past performance does not equal future returns). Over a longer time period this return should be better – historical performance suggests somewhere between 5 to 6% is the norm. But take a closer look and you'll see that over the last six months of 2015 this fund had a negative return of 6.11%, i.e. for a time you'd have been losing money. How would you feel about that kind of volatility?

In conclusion:

I understand your frustration at having locked in to a long term fixed rate (effectively insuring against rates going up), then seeing rates stay low for longer than most commentators thought. However, overpaying your mortgage is one way you can turn this situation into a pretty good deal for yourself – a 4% guaranteed return is one that most cash savers would envy.

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In response to comments, I've uploaded a spreadsheet that I hope will make the numbers clearer. I've used an example of owing £100k over 25 years at an unvarying 4% interest, and shown the scenarios with and without making a £100/month voluntary overpayment, assuming your lender allows this.

Here's the sheet: https://www.scribd.com/doc/294640994/Mortgage-Amortization-Sheet-Mortgage-Overpayment-Comparison

After one year you have made £1,200 in overpayments. You now owe £1,222.25 less than if you hadn't overpaid.

After five years you owe £6,629 less on your mortgage, having overpaid in £6,000 so far. Should you remortgage at this point that £629 is your return so far, and you also have £6k more equity in the property.

If you keep going:

After 65 months you are paying more capital than interest out of your monthly payment. This takes until 93 months without overpayments.

In total, if you keep up £100/month overpayment, you pay £15,533 less interest overall, and end your mortgage six years early.

You can play with the spreadsheet inputs to see the effect of different overpayment amounts. Hope this helps.