With savings rates finally paying some semblance of a decent return, deciding whether it’s better to pay off more of your mortgage or put your spare funds into a savings account has got a little harder. Here’s what you need to consider.
Many homeowners will long for the day when they’ll finally be mortgage-free. Making mortgage overpayments is one way to try to bring that day forward, whether by paying a little extra on your monthly payments when you can or by paying off a hefty lump sum.
It might seem a reasonable step to take, but with savings rates now finally paying some meaningful returns, many mortgage borrowers with cash to spare will be facing a dilemma: is it better to pay off my mortgage or should I put the money into a top-paying savings account instead?
“Overpaying your mortgage reduces the debt you owe and the interest you pay over the term of the loan,” explains Mark Harris, chief executive of mortgage broker SPF Private Clients. “If you have savings earning very little in the way of interest and your mortgage rate is higher, it makes sense to use your savings to reduce the interest on the mortgage.”
With interest rates rising and the cost of living increasing, many homeowners are facing the dilemma of whether it’s better to pay extra on their mortgage or put any spare funds into savings. This is an important financial decision that requires careful thought and number crunching. Here is a detailed analysis of the pros and cons to help you decide what’s best for your situation.
The Case for Paying Extra on Your Mortgage
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Reduces Total Interest Paid By paying extra on your mortgage principal you reduce the total amount of interest you’ll pay over the life of the loan. This can lead to substantial savings especially if you have a large mortgage balance.
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Shortens Loan Term Making extra payments can help you pay off your mortgage faster. This allows you to own your home outright sooner.
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Forced Savings: Some argue that paying extra on a mortgage is a form of forced savings since the money goes directly towards an asset. This prevents you from spending it on non-essential things.
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Peace of Mind: Eliminating mortgage debt can provide emotional benefits and peace of mind for some homeowners.
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Potentially Higher Returns Than Savings: If your mortgage interest rate is higher than you can earn on savings, paying extra on the mortgage may get you better returns.
The Case for Saving Money Instead
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Retain Flexibility and Liquidity: Money put into savings remains accessible for emergencies and other needs. Extra mortgage payments are locked up in home equity.
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Potentially Higher Returns: If you can find a savings account with an interest rate higher than your mortgage, you may want to save instead.
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Tax Advantages of Some Savings: Certain types of savings like ISAs provide tax benefits that mortgage payments don’t.
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Still Make Minimum Payments: You can grow savings while still making required mortgage payments to build home equity.
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Have Funds If Rates Drop: You’ll have money on hand to refinance or make a lump-sum payment if mortgage rates fall in the future.
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Save for Other Goals: Money can be saved for other important goals like retirement, college, or a future down payment.
Key Factors to Consider
When deciding whether it’s better to pay extra on your mortgage or save instead, there are a few key factors to take into account:
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Emergency Fund: It’s wise to have 3-6 months of living expenses set aside first.
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Mortgage Interest Rate vs. Savings Rate: Compare rates to see which option gives better returns.
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Mortgage Type: Extra payments on adjustable-rate or interest-only mortgages may make more sense.
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Time Horizon: Those closer to retirement may favor liquid savings. Younger buyers may want to pay extra on mortgages.
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Tax Situation: Savings like ISAs provide more tax advantages for some based on income/tax bracket.
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Future Plans: Will you need funds for other goals like education, relocating, or starting a business?
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Risk Tolerance: Paying extra on a mortgage guarantees saving on interest but provides less flexibility.
Do the Math for Your Situation
To decide what truly makes more financial sense for you, run the numbers for both options. Calculate the total interest savings from extra mortgage payments versus potential earnings on various savings vehicles.
Look at the after-tax returns, factoring in tax benefits of certain savings accounts. See how quickly extra payments would let you pay off your mortgage.
Use mortgage and savings calculators to model different scenarios. Crunch the numbers based on the amounts you can realistically put towards either option. This will give you the data you need to make the optimal decision for your needs.
Seek Professional Advice
It’s smart to consult a financial advisor when deciding between extra mortgage payments and savings. An advisor can review your full financial situation, risk tolerance, time horizon, tax considerations and other factors. They can then provide guidance on the best path forward.
Advisors can also help run calculations, determine ideal savings rates for different goals, and set up a coordinated long-term financial plan. Their expertise can give you confidence that you are making the right choice regarding mortgage payments versus savings.
Weigh Your Priorities
At the end of the day, you need to weigh your own financial priorities and what makes the most sense for your situation. Paying extra on your mortgage guarantees reducing your interest costs. But saving provides more flexibility, liquidity and potential diversification.
If you still can’t decide after doing the math and seeking professional advice, find a balanced approach. Pay a little extra on the mortgage while also building your savings. This allows you to realize some of the advantages of both strategies. By understanding the trade-offs and analyzing the numbers, you can make an informed choice on the best use of your extra funds.
Do you already have savings or other debt?
Before rushing off to check the interest rate on your mortgage and how it might compare to top savings rates, give some thought to other aspects of your financial situation.
“It is important to remember that money overpaid is virtually impossible to get hold of again, so you should keep funds back for a rainy day rather than putting everything into the mortgage,” says Harris.
The usual recommendation is to have enough savings set aside as an emergency fund to cover at least three months of your typical living expenses, and perhaps even six. The money should also be easy to access, in case you need it quickly. But even when you’ve set up your rainy day fund, paying more off your mortgage might not be the right option for your individual circumstances.
“It is not the best idea to overpay on your mortgage if you have an outstanding debt on a credit card or overdraft,” Harris adds. “You are likely to be paying a significantly higher rate of interest on the latter while the mortgage rate is comparatively lower. Therefore, it makes sense to pay off the expensive debt first before turning your attention to cheaper debt.”
Have you done the maths?
Trying to work out if it would be better to overpay your mortgage or put the funds into savings is then the key. Spending time playing around with a mortgage overpayment calculator to see what difference the extra money you can put into your mortgage will make might help inform your decision. At the same time, using a savings interest calculator will give you an idea of the return you would get by putting the money into savings.
As a general rule of thumb, if your mortgage rate is higher than the best savings rate you can get, a strong argument can be made that you should reduce your mortgage rather than keep your money in cash.
“Overpaying the mortgage is generally a good idea inasmuch as the interest on deposit accounts tends to be 2% below the mortgage base rate, therefore the rate of return achieved by repaying the loan is higher than when depositing in a savings account,” says Alan Lakey, director at Highclere Financial Services Ltd. He adds that people often derive psychological benefits from seeing their mortgage balance decrease more rapidly too.
However, if the situation is reversed, and you’re on a low, fixed-rate mortgage while higher savings rates are available, you might be better off putting the money in a savings account to make the most of the higher returns. “At a later date, when the mortgage rate increases, the funds can be used to make a lump sum overpayment,” suggests Lakey.
Should You Make Extra Mortgage Principal Payments?
FAQ
Is it better to overpay a mortgage or save?
If your mortgage interest rate is higher than the interest you’re earning on savings, overpaying your mortgage could makes sense. But if your savings rate is higher, keeping money in savings could be a better option.
What does Suze Orman say about paying off your mortgage early?
Personal finance guru Suze Orman says it depends. While the possibility of job loss can trigger financial panic, Orman advises against rushing to drain your savings to pay off your mortgage early. Even if you have enough money saved to wipe out your mortgage, don’t pull the emergency cord until absolutely necessary.
How can I pay off my 30 year mortgage in 10 years?
- Increase your monthly payment. This one is straightforward—just commit to pay extra every month. …
- Make extra payments. …
- Refinance to a shorter term. …
- Downsize your home. …
- Invest towards your mortgage payoff.
What does Dave Ramsey say about paying off a mortgage?
Opportunity costs To be fair, Ramsey does not advise paying off your mortgage as a first step. He wants you to pay off all of your other debt first and then start setting aside 15% of your money to stick in mutual funds. Only after you do these things does he tell you to pay off your mortgage.