Overpayments clarity

James_Renshaw

Hi,

I'm a little confused about overpayments.

We overpaid our mortgage a few years back, putting about £15,000 worth of savings into the mortgage. This obviously brought down our payments, and helped pay off a chunk of the loan.

A friend had recommended we overpay with our savings, because they were interest free, and that they would bring the payments down (which they did).

Now we're 5 years later, coming to the end of our current fixed term deal, and looking to remortgage at a much better rate. We've found the one we want (10 years fixed with First Direct), but are confused about overpayments.

I was under the impression that keeping the loan term the same (that is 31 years), then having the monthly payments drop by £150 to £600 thanks to the lower interest rate, we'd be able to overpay that £150 a month, which would be better for us than paying the £750 and reducing the term. My theory that this would be better was because the over payments are interest free, and the more we pay towards it without interest, the less interest we pay.

However the mortgage advisor we spoke to at First Direct told me that because the interest is calculated daily, overpaying £150 on top of £600 each month would be the same as paying £750 and reducing the term instead. Is this correct? Or is he trying to stop me paying less interest?

It may seem a stupid question, but after seeing our past mortgage payments fall dramatically when overpaying, it seems like overpaying was the way to go, especially when it's interest free. That being said, I might be missing something, and I doubt the advisor would lie, as the calls are of course recorded. He said dropping the payments and overpaying is something you'd do to give you flexibility, rather than a better deal.

To put it bluntly, is paying a smaller amount each month and overpaying (£600, overpaying £150) better than paying a larger amount per month (£750), or doesn't it matter?

Sorry if I've not explained this well, I'll try to clarify if needed. Any help or explanation would be appreciated.

Thanks,

James

AnotherJoe

In both cases you are paying £750 a month so why would it make any difference which way you paid them, the maths is the same in both cases ! All overpaying* is doing is making the "smaller" amount the same as the "larger" amount. So they are both the same amount.
So the end result must be the same, if it wasn't there's something wrong with fundamental maths.
And apologise in your thoughts to the call centre operative for your conspiratorial thoughts as to how they are trying to make you pay more interest.

* also don't be in such a rush to pay off a low rate loan when higher rate opportunities such as pensions are available. Too many focus on mortgage at all costs and wake up 20 years later and wonder why their pension will be so meagre.

ThePants999

The mortgage advisor is right. Having a £600 mandatory payment but choosing to overpay by £150 has the same effect on your total payments as having your repayments set at £750 and not overpaying - but you get flexibility, as you can choose not to overpay if you find yourself in sudden need of the extra £150.

James_Renshaw

Thanks for your replies,

I was under the impression that, as the extra £150 overpayment was interest free, that was £150 per month I would not be paying interest on. But if it doesn't make a difference, then I'll keep it at a higher amount and drop the term.

ThePants999

Hang on a sec - I misunderstood what you said the mortgage advisor was saying. I have the opposite advice!

What you just said doesn't make sense in the way you think it does, so you're right AND you're wrong Interest is charged on what you owe, not what you pay.

I'm going to make up some numbers, since I don't have your real ones. You take out a £150,000 mortgage at 2.65% over 22 years. Without accounting for repayments, borrowing £150K at 2.65% means you're paying £331.25 in interest every month. But on a repayment mortgage, they set your monthly payment at a level that means you pay off the capital as well over the term of the mortgage. Specifically, for these numbers, the repayment is set at £750.

In the first month, then, you pay £750 - £331.25 of that was interest, so £418.75 of that is actually paying off the mortgage, leaving you owing £149,581.25. Because you now owe less, you're paying less interest - in month 2, you only owe £330.33 in interest, which means when you pay £750, slightly more of that is actually paying off the mortgage. It keeps going like this - ten years in, you owe about £92,500, which means you're only paying about £200 in interest and the other £550 is reducing your debt. By the time the mortgage is nearly finished, you're paying practically no interest at all.

If you increase the term to a little over 30 years, the repayment changes to £600. That's because the amount of interest you pay each month doesn't depend on the term of the mortgage, it only depends on how much you owe (and the interest rate). So in the first month, you're being charged the exact same £331.25 in interest - the difference is that you're only paying £268.75 on top of that, so you're left owing £149,731.25. That means next month's interest is £330.66 - higher than in the previous example, which means that you're paying off even LESS of the mortgage than in month 2 of the previous example. This compounds every month - so after 10 years on this scheme, you instead still owe £113K and are paying £250 a month interest, so only paying off £350 a month. The result being that it winds up taking 8 years longer to pay off the mortgage.

But what happens if you choose to overpay by £150 in the first month? Well, the £331.25 interest was already covered, so every penny of the overpayment goes towards reducing what you owe. So you owe £150 less in the second month - £149,581.25. Interest on that is £330.33... hey, look, that's exactly the same as the first example! Sure enough, if you overpay by £150 every month, you end up paying off this "30 year" mortgage in 22 years. Exactly the same as if it had been a "22 year" mortgage to begin with.

That's what you really mean by the overpayment being "interest free". It's all going towards capital repayment. As you say, the extra £150 is "£150 a month you would not be paying interest on". But the thing is, when you compare the 22-year mortgage and the 30-year mortgage, the difference between the £600 payment and the £750 payment is all going towards the capital too. It's STILL So basically, reducing the mortgage term is signing up to mandatory overpayments.

Hence why I don't recommend the course of action you just decided on. There's no difference between signing up to a shorter term that gives you a £750 monthly payment, or keeping the current term, having a £600 payment but then overpaying by £150 a month. Both courses of action pay off the mortgage at the same time and result in you paying the same total interest. But the shorter term FORCES you to make that higher payment, whereas the longer term gives you the flexibility to hang onto that £150 any time you need to (at the cost of paying off the mortgage later and paying more total interest).

AnotherJoe

James_Renshaw wrote: »

Thanks for your replies,

I was under the impression that, as the extra £150 overpayment was interest free, that was £150 per month I would not be paying interest on. But if it doesn't make a difference, then I'll keep it at a higher amount and drop the term.

Well then, to quote Monthy Python, you're just a very silly boy, because the term will still end up being the same in practice, eg it will end up being paid off at the same date whatever the theoretical term is of the lower amount per month, however in your method you will be locked into that £150/month payment with zero flexibility, whereas if you do as the adviser suggested and go for the £600 with voluntary overpayment, you have flexibility.

And as TP999 pointed out you seem to have a misconception about what you pay interest on. You pay interest on what you owe, the whole total sum, not what you pay in each month!

James_Renshaw

Thanks again for the further replies. I now understand how the overpayments work, and that it doesn't make a difference as to whether I pay over or not.

The advisor was advising us more towards paying the £750 each month, and we're actually in agreement. I know that we don't get any flexibility that way, but we have secure jobs, and have been comfortably paying off the £750 a month for the past 5 years, so that's not an issue.

What might happen with the flexibility is that we'll be tempted to spend that £150, so we'd be setting up a standing order anyway. So we'll definitely go for the lower term now that I know it doesn't make a difference, and will put us in a good position in 10 years time.

Thanks for all your help though.