What should I pay off first?

Yarvisan

In 2022 I bought a property with my partner valued at £440,000. We borrowed £15,000 from my parents to buy our house. The terms of the loan were that it could be paid back at our discretion, with no set date but most likely over 5 years, and a yearly interest rate would be applied matching the rate offered by my parents bank. The interest rate is adjusted each year to ensure it stays up to date. At the end of each year (from when the loan started) we could either pay off the interest or add it to our total loan amount. Last year we decided to pay off £3,000, so the current outstanding loan amount is currently £12,000. In the event that we sell the house, my parents will be paid back immediately from the proceeds.

Current interest rate on the parent loan: 4% (unsure if this will change)

Current mortgage rate: 3.9% (but expected to increase to 4-4.5% when remortaging)

When we first bought the property we took out a 3 year mortgage for £375,000 (now at £370,000). This mortgage is due to expire in May 2025, in which case we will be looking to remortgage at the cheapest rate possible. Based on current rates it's likely our monthly payments will go up when we remortgage by a significant amount, which we want to avoid if possible.

My question:

Given the 3 different scenarios below, would we be financially better off by paying off the loan to my parents first, before starting to over pay our mortgage? With the volatility of interest rates currently, we want to try and reduce our mortgage as much as possible so that we can fix into the lowest possible deal for maybe 5 years or more. Ideally we want to overpay our mortagage to hopefully significantly reduce the interest and term in the long run, but also wondering if there is anything we can do now to keep our mortgage payments down when renewing next year, such as overpaying monthly or a lump sum. But at the same time, we are also keen to exceed expectations and pay off the loan to my parents as soon as possible. We're not sure which option would put us in the best financial situation and create the lowest long term debt possible. 

- Loan interest rate and mortgage rate are the same or negligible

- Loan interest rate is higher than mortgage rate

- Loan interest rate is lower than mortgage rate

londoner2019

Hi - I would personally seek to pay the loan from your parents as soon as possible. It's great (and quite rare) that you have agreed terms in place regarding interest, but I would argue the longer it's seen as a low priority debt, the more likely it is you'll continue to see it as a low priority debt. When money comes between family and friends, it can get uncomfortable.

13thlegion

I think the non-financial benefits of paying off your parents first far outweighs the financial benefits of overpaying the mortgage.

Let's look at a best case scenario - being able to pay off the £12,000 by May 2025 (whether or not this is realistic doesn't matter for this example)

Option 1: Parents are paid back, freeing up money to tackle higher mortgage interest rate

Option 2: Mortgage balance reduced by £12,000 by May 2025. You still have to pay your parents back and mortgage payments go up anyway. As of now your mortgage is around 84% of the house value, and £12,000 will only knock a further 2.7% off that which won't be enough to push you through one of the main thresholds of LTV (loan to value) that would drastically affect your mortgage interest rate.

In any other scenario where you are able to pay off less than the full £12,000 the impact on your mortgage is even less. Paying off your parents faster on the other hand will have greater emotional significance for both you and your parents, and allows them to provide further support in the future if you ever need it. And from a purely behavioural perspective paying off smaller balances first does work well as you get to finish lines quicker.