Calculating if it's worth swallowing Early Repayment Charges

andyeb

We've just moved house and our mortgage just tripled in size - this will almost certainly be the most amount of money we will ever owe anyone and we are therefore keen to get ahead with payments. We were conservative with how much we borrowed and the payments are quite affordable now, but no one knows what interest rates will be like when the 5 year fixed rate comes to an end.

Since moving, we decided to move more slowly with home improvements and put a chunk of our savings into the mortgage, maxing out the annual 10% overpayment which can be made without incurring Early Repayment Charges.

We now have to decide whether to reduce the monthly payments or reduce the term of the mortgage. If we do nothing, we'll incur ERCs on the amount we end up over paying.

But this got me thinking - although it's never nice to hand over cash for nothing (e.g. ERCs) - is it always financially inadvisable to do so? I've been trying but failing to work this out and I wondered whether anyone could shed any light on the situation or offer help on how to work it out?

Here are the details:

mortgage outstanding (after 10% overpayment): 300k
interest rate: 2.09% (5 year fixed rate)
ERC in first year: 5% of amount overpaid (beyond permitted 10% overpayment)

My question is therefore: if we have spare cash at any point in the next year, should we put it in the mortgage and swallow the ERC, or put it in savings (ISA with pittance interest rate) and then move it into the mortgage on the anniversary of completion?

Thank you!

getmore4less

There are some good rates out there if you do some work.
fill all those up that net over 2.09 first

even 0% savings you save next 2 years 10% ERC free payments next(max saving y1 2.09%+ y2 2.09%, cost 5%.

Probably over £2kpm just with those do you have more than that?

40% tax payer there is pension.

if the ERC drops to 4% at some point you need to factor that.

Easy way is £100 overpayed costs £5 and saves £95*0.0209%/12 per month.

shadyadie

This is also something I'm trying to figure out. my interest is 2.99% and early repayment is 3%. So if I overpay incurring the charge does this balance out to zero lose / zero gain?
At the interest rates I can get on savings I'm thinking it might as well go straight in to the mortgage?

ThePants999

@OP - what you need to figure out is: if you didn't repay it now, when WOULD you?

If you're planning to repay 10% every year for the foreseeable future, and you have a one-off sum that would take you over, then you'd have to wait many years (at 2% interest) before you could pay it without penalty. So you should take the penalty and pay it off now.

If you have a sum you want to overpay this year, but next year you're not expecting to make overpayments, you might as well wait. You're paying 2% to avoid 5%.

@shadyadie - in your scenario, something to bear in mind is when the annual overpayment allowance "resets". E.g. if you can overpay 10% per year, is that per 12-month period starting when you took out the mortgage? Because if it's coming up soon, then you can make savings by overpaying 10% now, and the rest once you've got another 10% allowance, as you're not going to pay a whole year's interest in the interim. If it's just passed on the other hand then yes, you might as well just overpay now - it works out as pretty much a wash in the first year, and saves you thereafter.

glosoli

It is worth while investigating whether increased direct debit payments count towards your 10% allowance. I know a couple of banks where you can make lump sum repayments of 10% of the balance, and then can still overpay above and beyond that through increased direct debit payments. It may be worth investigating.

SouthLondonUser

@OP, so the 5-year fixed term has just started, right? What is the term of the mortgage? 20 years?

Do you know your way around spreadsheets? If you know at least the basics you could download one of the many mortgage amortisation templates and make a few modifications. You need to calculate and compare the following, from now till the end of the 5-year fix:
1) How much it costs you to overpay: on one hand the early repayment charges may seem money down the toilet, on the other hand overpaying will reduce future interest rates
2) The interest you would pay on the mortgage without overpayments, minus what (presumably) little interest, net of tax if taxes are applicable, you would get investing the money you don't overpay into a saving account.

Remember, when comparing the costs of these options, you have to take into account the cost of interest only. Having £100k of equity in a house + £20 in the bank is the same wealth as having £110k of equity + £10 in the bank.

SouthLondonUser

I have made a very simple calculation in a spreadsheet, and uploaded it to dropbox, but as a new user I cannot post links. If you add the following:

/s/7hnmb68zzpu9ty4/MortgageExample.xlsx?dl=0

after the dropbox dot com web address you should be able to download it.

You should be able to open it even with a free software like OpenOffice. It is an xlsx file, so you can be sure there are no macros nor anything malicious!

I had to make a few assumptions, which you can easily change in the spreadsheet:

1. Mortgage term = 20 years
2. Current Balance = £ 300k
3. Amount to overpay: £5k, available now
4. The alternative use of the £5k is to invest them now for 12 months in a 1.5% ISA

With these assumptions, my results (comparing over 12 months) are:

No overpayment:
Interest paid: 6,153
minus interest on ISA: 75
Total cost: 6,078

Overpayment:
Interest paid: 6,059
plus overpayment penalty: 250
Total cost: 6,309

With these assumptions no, it's not worth overpaying.

getmore4less

No need for a spreadsheet if doing over 1y with that 1.5% ISA

The cost of overpaying is is 5% the saving is 2.09%+1.5% net COST 5-2.09-1.5= 1.41%

SouthLondonUser

getmore4less wrote: »

No need for a spreadsheet if doing over 1y with that 1.5% ISA

The cost of overpaying is is 5% the saving is 2.09%+1.5% net COST 5-2.09-1.5= 1.41%

No, that's wrong. If you overpay, you are not investing that money at 1.5%, so 1.5% becomes an additional cost, because you are giving up the 1.5% you'd get without overpayment, plus you are paying 5% penalty, and all of this to save only 2.09% of interest.

The cost of overpayment is therefore: 5% - 2.09% +1.5% = 4.41%

Note that this is an approximation because it does not take into account the fact that the mortgage is not interest only, and therefore the amount of interest repaid changes in each period.

The approximation is, however, still decent with these amounts and over short time horizons. Specifically, the cost of overpaying as per my spreadsheet is 231 ( = 6,309 - 6,078), which is 4.62% of £ 5,000.

getmore4less

you are right got that the wrong way round

I also forgot the over payments if you keep the normal payments the same.

£300000 20y 2.09% £1531pm after 1y owe £287,781 - (£5k *1.015) £5,075 = £282,706 net debt

Overpay £4762 fee £238

£295,238 2.09% £1531pm after 1y owe £282,919 net debt

£213 more.