I overpay my mortgage as well as investing into my portfolio. There’s an opportunity cost, but here’s why I’ve overpaid my mortgage for 3 years.
The argument against overpaying a mortgage
There are some strong arguments against overpaying a mortgage for financial independence:
1. Liquidity crunch
If you overpay your mortgage, you’re committing cash to an asset (house/ flat/ boat/ bathroom in a “luxury London condominium” that you get to sleep in during daytimes) that isn’t liquid. Yes, you can sell said home, but it takes time. Months, typically. There’s no guarantee that when you want to sell, someone will pay the asking price for it.
By overpaying the mortgage, you put yourself at risk of needing that cash later. Hey ho.
2. Opportunity cost
Overpaying a mortgage comes with a nominal return of whatever your mortgage interest rate is. Mine’s a little over 2.3% (we fixed in for a long time). If you take off a generous 2% to account for inflation, overpaying my mortgage gives me a crummy real rate of return of… 0.3-and-a-bit %.
That’s better than cash savings in 2021. By quite a way, in fact – depressing as it sounds. So, why’s that bad?
I have the opportunity to use this money for anything before I overpay. That includes better money-making schemes, like investing in my ISA or in shares or crypto or on Crowdcube… you get the picture. Any number of opportunities exist to me that come with a better real rate of return. So, by overpaying the mortgage, I am turning down these great opportunities.
3. Homes are not assets – they’re liabilities
In the UK, we’re in the luxurious (assuming you’re already on the ladder in your forever home) position that property prices tend to keep increasing. Doubling every 20 years or so. This is partially due to inflation and how money is created, but it’s also just a function of supply and demand: we don’t build homes fast enough for a growing population.
This means that we usually think of homes as a wise investment purchase. After all, the price just keeps going up! Surely it’s an asset?
Maybe. Strictly speaking, you can sell your home. It can be done. However, you’re probably not going to do it, unless you plan to do it to a) buy another home, whether bigger or smaller, and b) accept that you’re going to be renting next. It’s an asset that’s pretty much useless for anything other than sleeping in and storing your stuff/ family/ pets. That was my big criticism of net worth as a measure.
What a home definitely does do though is add to your bills. Mortgage interest, new windows and doors, repointing brickwork, gardening, maintaining patios/ decks/ balconies, replacing kitchen appliances…
… but wait, there’s more! An idea I lovingly stole from The Millionaire Next Door: you’ll maintain a lifestyle in keeping with where you live. Even if it’s not intentional, you’re not about to buy a flat in Knightsbridge to take your partner to Wimpy for a cheeky meal out, it’s not likely to happen. You’re going to an upmarket “industrial chic” restaurant for that casual dining experience, and you know it.
The point is that homes cost you money, directly and indirectly, and there’s nothing you can do about it. So, by paying more into the home, I’m not building my financial independence assets which I’ll need to sustain me.
Those are some good arguments. So, why are you overpaying a mortgage instead of building wealth?
Good question, presented savagely. I approve.
If you look back to my financial independence campaign plan for 2021, you’ll see that I’m aiming for coastFI. You can read more about coastFI and different “types” of financial independence here if you’d like more explanation. I don’t think I’m going to be truly retired in my early 40s, I just want the freedom to do whatever I want for money, knowing that it doesn’t matter if I earn big bucks or pennies.
I aspire to be self-employed. I think it would be pretty cool to just have lots of small, flexible income streams, or to build something myself. Lots of side hustles, or the freedom to pursue a business idea just because it got fun. I enjoy this more than I enjoy working for companies, but side hustles alone don’t pay the bills, so I am trying to invest my time into thinking of business ideas that I’d like to run instead of my current employment.
Why this matters
Self-employed people have difficulties obtaining mortgages at high Loan-To-Value (LTV). This is an obstacle to planning and a disincentive to take the risk and start up when I do (eventually) find the idea I want to run with.
Interestingly, mortgage brackets and difficulties tend to stop when you hit 60% LTV. That means that when I (and my partner) own 40% of the home and the Bank owns 60%, we gain a huge chunk of freedom.
That’s encouraging for me so I make overpayments to accelerate the process. Small overpayments, too. We aim to hit 60% in the next 12-18 months.
Making the most of overpaying a mortgage
In a mortgage, just like any long-term debt, compound interest is operating against you. Sucks, doesn’t it? I suspect that this is a big reason behind the growing divide between rich and poor. Poorer people living on credit get the parabolic (exponential maybe? It’s been a long time since I last studied maths) curve working against them, usually at 15-40% APR. Meanwhile, wealthier people get the parabolic curve of 3-20% growth working for them in their investments.
Morgages aren’t too bad. The average interest rate on a 2-year fixed rate mortgage in December 2020 was 2.49%. As debt goes, that’s dirt cheap. If you’re not aspiring to self-employment or whatever, it’s super easy to beat this penalty by a return from investments.
Importantly though, repayments reduce your capital before interest is charged that month. That means that adding a set overpayment (say, £200 extra per month) will increase the amount that your mortgage is being overpaid by. This happens because the monthly total bill gets smaller: you pay a mixture of capital and interest in most residential mortgages every month, which you’re reducing with each overpayment, but you’re then adding a fixed sum on top.
We actually do one better and pay a set total amount each month, which means our bills stay the same but our overpayments grow as our interest payments shrink.
How much can you overpay into a mortgage?
In theory, you can overpay on most mortgages. It’s rare to find a mortgage where you can’t overpay. However, on some mortgages there is a penalty fee for overpaying, to make up for the interest payments that the lender isn’t getting anymore.
Our mortgage allows us to pay up to 10% of the balance annually before we’re charged a penalty fee. That’s a little under £15,000, which is significantly more than we could overpay without really tightening our belts and going hell-for-leather.
If you want to overpay your mortgage, it’s worth checking your terms and conditions to see what penalties (often called “early redemption fee” or “administration fee”) apply.
How much I overpay on my mortgage
If you’ve read this far, you’re probably as nosy as I am when I read other financial independence blogs. You’re just dying to see some of those numbers.
The way we worked it was simply to add £200 onto our mortgage payments (which, when we were still at 90% LTV, sucked pretty hard). We re-mortgaged after the fixed interest period ended, then added £200 to that figure and let it ride. Our overpayments had dropped this by around £150 anyway, so we didn’t notice much change in our combined bills.
At the time of writing, the mortgage stacks up like this:
| Item | Figure |
|---|---|
| Value of our house, according to the bank | £222,327 |
| How much we owe | £142,951.08 |
| Our interest rate until end of 2023 | 2.38% |
| How much we pay in every month | £877.55 |
| How much the bank want us to pay every month | £651.03 |
| Our overpayments at the moment | £226.52 |
| Our current LTV, according to the bank | 64% |
| The target LTV | 60% |
| Assuming that our house doesn’t increase in value, how much debt at 60% LTV? | £133,396 |
| When do we hit 60% LTV? | 1 year 4 months (November-December 2022) |
How do you arrange to overpay a mortgage?
It’s remarkably easy. My mortgage company will allow you to do it on the phone or by the internet.
Note: the banks sometimes mess this up. Our bank somehow added the overpayment on twice, cancelled the spare so we then we got billed the right amount – but they sent us the letter as if we’d missed mortgage payments. Cue lots of automated junk mail on debt advice and nuisance calls from a debt helpline.
Thanks, bank! You’re the best! No wonder crypto and DeFi are so popular.
The payments come out with the mortgage direct debit, if you pay by direct debit like I do. It comes out as a single payment from the bank.
I have heard that there used to be an advantage to pay by credit card for the rewards, but my bank charges me a fee for credit cards and my rewards suck. Direct debit it is.
Sounds great! Why not maximise overpay the mortgage as much as you can early on, then invest later?
There’s a pretty good argument that suggests paying off the mortgage as fast as you can will give you more freedom to invest later. That’s actually an option for my partner and I. We could dramatically cut our investments and pay the mortgage off at three times the rate, clearing it well within 10 years and effectively neutering that threat of homelessness. It’s something we talked about before this whole financial independence campaign started.
The problem with that is, well, all of the arguments in the first section. I’m a vocal fan of diversification. It’s hard to diversify if all you have is an emergency fund and a shrinking liability for a decade. If anything happens, that’s not a lot of fat in the liquid portfolio to live on!
What’s the plan, then?
My share of the overpayments is about £113 (i.e. about half of our total). That’s not far off my SIPP contributions, and it’s less than my ISA contributions. It’s a small compromise in the scheme of things, small enough that it shouldn’t slow me down too much from financial independence but large enough that it makes a decent amount of progress towards the target LTV.
An interesting oddity is that mortgage companies reduce your interest payments for every 5% LTV you own. So, 85% LTV mortgages charge less interest than 90% LTV mortgages. However, that all stops once you clear 60% LTV: there’s no residual benefit. You’ve not going to be offered cheaper rates unless the interest rate of the Bank of England drops, and it’s pretty much zero now. It’s my assessment that it’s not worth us overpaying any further at this point, as we will have gained the freedom I’m after but we’ll be better off earning a greater return on, well, any other asset class, that could then be used to clear the mortgage if we want to.
So I guess in November 2022 that’ll be the end of overpayments for us. We’ll see in the 2023 campaign plan how that goes!
