Overpaying an interest-only mortgage if you have extra cash may seem an obvious option – but it may not be the best
Is the mortgage market turbulence getting you down? Have you got a mortgage-related question you need answering? Email in, and we will get one of our experts to reply. Nick Mendes, mortgage technical manager at John Charcol, has given his advice to a reader below. If you have a question for our experts, email us at money@theipaper.com.
Question: With an interest-only mortgage, is it a good idea to overpay each month to reduce the capital or is it better to pay the interest only and use the overpayment money to invest?
Answer: At first glance, the decision appears straightforward. If surplus funds are available each month, directing them towards the capital would reduce the outstanding balance and, ultimately, the sum that must be repaid at the end of the term.
With an interest-only mortgage there is no requirement to repay the capital during the term, although voluntary overpayments are permitted. Regular monthly payments cover only the interest on the loan, meaning the original borrowing remains unchanged unless overpayments are made.
When the term ends, the remaining capital must be repaid in full, typically through accumulated savings, investments, or the sale of the property.
This flexibility is one of the principal attractions of interest-only borrowing. It can, however, also prompt some borrowers to retain their additional funds for alternative uses, such as investing, in the expectation of achieving higher returns.
The question, therefore, is whether the certainty of reducing the balance now is more beneficial than the potential for greater growth through investment.
The case for overpayment is straightforward. Reducing the capital lowers the interest payable over the life of the mortgage, delivering a saving equivalent to the mortgage rate itself.
For example, with an interest rate of 5 per cent, each overpayment effectively generates a risk-free return of 5 per cent. This is unaffected by market volatility and provides a guaranteed improvement in the borrower’s financial position.
The investment route offers the possibility of higher returns, but with inherent uncertainty. Over extended periods, well-constructed investment portfolios have the potential to outperform mortgage interest rates, yet there is no assurance that such performance will be achieved within the relevant timeframe.
To exceed the benefit of overpayment, investment returns would need to surpass the mortgage rate after both tax and charges, and this would have to occur consistently rather than in isolated years.
There are also practical considerations. Overpayments are, in most cases, irreversible; once funds are directed towards the mortgage, they cannot be easily accessed. This may be a disadvantage for those requiring liquidity, although for others the reduction of debt provides valuable peace of mind and a tangible sense of progress.
Borrowers should also be aware of lender restrictions. Many allow overpayments of up to 10 per cent of the outstanding balance each year without penalty during a fixed-rate period, though terms vary and early repayment charges can significantly reduce the benefit of large lump-sum payments.
For those inclined to invest, maximising tax efficiency is essential. A stocks and shares ISA permits annual contributions of up to £20,000 free from UK income and capital gains tax, while pension contributions attract tax relief but remain inaccessible until at least age 55 (rising to 57 from 2028).
Although such vehicles can enhance net returns, the higher potential yields are accompanied by a greater degree of risk.
In practice, a balanced approach is often adopted, with surplus funds allocated between overpayments and investments. This strategy provides the certainty of reducing the mortgage balance while retaining the opportunity for capital growth.
There is no universal answer to the overpay-or-invest question. Interest rates, investment conditions and personal circumstances evolve, and what is optimal today may not be so in future years.
Those relying on investments to clear the mortgage at term end should be realistic about projected returns and may wish to incorporate some level of overpayment as a safeguard.
Conversely, for those who prioritise certainty, the guaranteed benefit of reducing the capital can be more valuable than the possibility of higher, but less predictable, investment gains. Seeking advice from both a mortgage broker and a financial adviser can help ensure that any approach taken is appropriate for your objectives and circumstances.