For a long time I’ve been trying to understand when it makes most financial sense to stop making mortgage overpayments and invest your savings elsewhere.
I think it’s fair to say I was obsessed by this question for a long time, looking all over the internet for an answer which I hoped looked like a date or a number of months since my mortgage started. A magic formula that would make me feel and look just sooo financially smart!
It took me a while to understand that I was looking at it the wrong way. The answer to this question is not as specific and strict as I initially had in mind, because it is not the same for everyone.
These are now the 3 rules that I follow when deciding whether to make a mortgage overpayment.
Cash flow and liquidity
If you have for example £10,000 and you pour it into your mortgage, you will pay a little less every month. (Alternatively you can chose to make your mortgage end sooner, depending on your mortgage contract.) But that money is then gone from your cash flow, and if anything unexpected happens, you can’t access it or withdraw it. It’s kind of “gone”.
Chances are that at some point in anyone’s life something unexpected will happen, so before you even start making any mortgage overpayments, make sure you have at least 6 month’s worth of cash and invest it so that you can access it quickly, if needed.
I have my 6 month’s worth invested in an Innovative Finance ISA through Funding Circle, a peer-to-peer lender. It’s an ISA, hence tax free, and it pays approx. 7.2% – calculated daily! In an average month I make 13 x what I used to make with my old cash ISA.
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Interest rates and mortgage age
Interest rates vary according to the type of debt (mortgage, car loan, credit card loan, etc.) so make sure you pay off first the most expensive debt, which is normally not your mortgage. You can consider paying off a small debt first, just to give you the excitement and adrenaline that comes with feeling free(er).
Even if you have to remortgage, this principle doesn’t change. Pay off your more expensive debt first. But interest rate is only one way to determine how expensive debt is. The other way is the length and age of your debt.
When you take out your mortgage for example for 25 years, your monthly instalments will initially be made up of a small part of capital repayment and a larger part of interest. It’s larger at the beginning because it is compounded over 25 year.
This chart shows the capital (principal) and interest curves over time.
It is financially smart to maximise any mortgage overpayments before you hit the sweet spot where the two lines cross. Of course this sweet spot is just an example and is different based on your specific mortgage deal.
How you feel about debt
I personally dislike debt. A lot. My mortgage is the only debt I have. I have two credit cards which I pay off completely and automatically every month, and that’s it. No weakness nor regrets.
Even when I will reach the sweet spot where investing my money elsewhere would make me more money, I am likely to put some money into overpayments, so that I can get rid of all my debt. It’s a mental thing that makes me feel better.
And when you feel better, you make better decisions and live an overall better life.
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