Mortgage overpayment: reduce term or monthly payment?

JayZed

This came up on another thread but there wasn't really a definitive answer there. I'm in the happy position of being able make regular overpayments on my mortgage (up to the max allowed). The question is, should I reduce the term or reduce the monthly payments?

My assumption is that it's better to reduce the term as this will reduce the overall amount of interest that I pay, but some comments on another thread made me think that it might actually not make all that much difference. Am I right to think that it's best to reduce the term?

Bear in mind that I'm not likely to need to borrow this money back in the near future - in other words, flexibility/ability to make lower payments is not an issue for me, it's simply a question of what's going to cost me less over the long term.

m1ntie

Sorry not quite sure what you are asking - if you reduce the monthly repayments you will increase the term.

ThriftyBeanie

There is only really one answer for you: use your overpayments to reduce the term. Over the life of the mortgage, this will cut your interest expense.

If you chose to reduce monthly payments, then you wouldn't be overpaying anymore.....

snarffie

This is a question that gets asked every day.

Basically, you can do it either way and pay EXACTLY the same interest.

eg. for a £100k mortgage @ 6% aiming to pay in 25 years.

Mortgage1: 25 year term.

£644 per month
£93,000 interest over the term
paid off in 25 years.

Mortgage 2: 30 year term (with overpayments)

£599 per month
overpay £45 per month
£93,000 interest over the term
paid off in 25 years (5 years before natural term)

Both have exactly the same payments, and are paid off at exactly the same time.

The only difference is that Mortgage 2 allows you to pay the 'minimum' £599 in months where you might be struggling. Of course, if you do stop overpaying Mortgage 2, even for 1 month, you have to either a:make up for the overpayments or b:accept that the term (and total interest) will increase because of the 'underpayment'.

treliac

snarffie - isn't your illustration more relevant at the start of the mortgage when you are deciding on the term to pay over?

Once you are part way through, say a 25 year mortgage, and you can start making overpayments, then these can be as and when you can afford. If one month you need the money in your pocket there would be no penalty if it's a voluntary arrangement, surely.

Presumably, you can decide to reduce the term, keeping the original loan amount at the same level.

Or you can pay off some of the outstanding loan balance and if you maintain the original term then payments would automatically become smaller, hence you would not be overpaying.

That seems logical but my understanding is pretty basic !!!

treliac

JayZed

I've just seen the other thread on the Mortgage-free Wannabe.

Doesn't your own post say it all?

http://forums.moneysavingexpert.com/showpost.html?p=11070063&postcount=14

snarffie

treliac wrote: »

snarffie - isn't your illustration more relevant at the start of the mortgage when you are deciding on the term to pay over?

Once you are part way through, say a 25 year mortgage, and you can start making overpayments, then these can be as and when you can afford. If one month you need the money in your pocket there would be no penalty if it's a voluntary arrangement, surely.

Presumably, you can decide to reduce the term, keeping the original loan amount at the same level.

Or you can pay off some of the outstanding loan balance and if you maintain the original term then payments would automatically become smaller, hence you would not be overpaying.

That seems logical but my understanding is pretty basic !!!

The principle works at any time when you remortgage. When you remortgage, you can decide to stretch the term out again if you want, depending on your age/lender's terms. I just remortgaged and applied the principle to my new mortgage (stretched out to 19 years from natural 14 year term).

mr_mortgage

snarffie wrote: »

This is a question that gets asked every day.

Basically, you can do it either way and pay EXACTLY the same interest.

eg. for a £100k mortgage @ 6% aiming to pay in 25 years.

Mortgage1: 25 year term.

£644 per month
£93,000 interest over the term
paid off in 25 years.

Mortgage 2: 30 year term (with overpayments)

£599 per month
overpay £45 per month
£93,000 interest over the term
paid off in 25 years (5 years before natural term)

Both have exactly the same payments, and are paid off at exactly the same time.

The only difference is that Mortgage 2 allows you to pay the 'minimum' £599 in months where you might be struggling. Of course, if you do stop overpaying Mortgage 2, even for 1 month, you have to either a:make up for the overpayments or b:accept that the term (and total interest) will increase because of the 'underpayment'.

That, indeed, is the 100% correct answer! (so long as you are allowed to make overpayments)

JayZed

Now I'm even more confused than when I started this thread! Snarffie's answer looks good, but it doesn't really answer my question because the monthly payments aren't being progressively reduced. Perhaps I didn't explain the options properly.

To keep the numbers simple, let's say that I have a mortgage of £200K over 25 years and I have to make a minimum monthly mortgage payment of £1000. I'm allowed to overpay up to £500 a month on top of this (which goes to capital repayment) and I have an unexpected windfall that I want to use to make the maximum overpayment every month.

So, in month one, I pay £1500 (£1000 plus overpayment of £500). Now the bank gives me two options:

(1) Keep the term at 25 years and reduce the minimum monthly payment by about £2 each time I make an overpayment (because the oustanding balance is lower). So in month two I pay £1498 (£998 + £500 overpayment); in month three I pay £1496 (£996 +£500) and so on. (I'm rounding the figures here).

(2) keep the monthly payment at £1000 and decrease the term. So I keep on paying £1500 every month (£1000 + £500 overpayment) but with each overpayment the remaining term decreases, so that I end up paying £1500/month over about 14 years rather than £1000/month over 25 years.

To be precise, what my lender says is "thank you for making an overpayment of £500 on your mortgage. As a result of your overpayment, your monthly payment will be reduced from £1000 to £998. If you would prefer to reduce your mortgage term instead, please contact us."

Rabiddog_2

Two points ..
1 the banks generally only re-calculate your payments annually

2. they certainly wouldnt be interested in reducing your payment by £2 a month .. there might even be a charge for changing your payment too frequently.

The Lender prefers you to have the mortgage for longer periods rather than shorter periods as they make more money, and also retain you as a marketing opportunity, sorry I mean customer.

JayZed

I'm not interested in reducing my payment by £2 a month, but apparently that's the default option if I overpay. In other words it seems to be what the lender (Nationwide, by the way) prefers.

I'm not sure that I understand your point about recalculating payments annually. Nationwide seems keen to do it every time I overpay - presumably because they prefer me to have the mortgage for a longer period. But does that mean that I end up paying them more interest?

I'm sure I'm getting good advice on this thread, I think I'm just being obtuse about the maths. I think I'm going to go ahead and tell them that I want to reduce the term, since I know that will save me a lot of interest over the long run.