Overpay the mortgage or save the money? How to compare the two

If you have money left over each month and a mortgage, there are two obvious homes for it: pay the mortgage down faster, or put it in savings. Both build wealth, but in different ways, with different risks and different levels of access. This guide works through one scenario with real arithmetic, then covers the charges, taxes and practical points that can tip the balance either way. It is a way to compare, not a recommendation.

How a mortgage overpayment works

On a standard repayment mortgage, each monthly payment covers that month’s interest first, and the rest reduces the balance. An overpayment goes straight to the balance. Because next month’s interest is calculated on a smaller balance, a larger share of every later payment goes to principal, and the effect compounds over the remaining term.

The return on an overpayment is therefore the mortgage interest rate: each unit overpaid saves interest at that rate for as long as it would otherwise have been owed. That “return” has three distinctive features. It is not taxed, because it is a cost avoided rather than income received. It is fixed for as long as the mortgage rate is fixed. And it is locked into the property rather than sitting in an account you can draw on.

Lenders usually let you choose, or set a default, for what an overpayment does: shorten the term while keeping the payment the same, or keep the term and lower the payment. Reducing the payment keeps the original end date. The examples on this page reduce the term.

Worked example: overpaying 200 a month

These figures assume the rate stays at 5% throughout. In practice many mortgages have a fixed rate for a few years and then move to a different rate, so long-range figures like these are illustrations of the mechanism, not forecasts. You can test other rates, terms and overpayment amounts in the mortgage calculator.

Overpaying versus saving the same 200

A fair comparison puts the same money, over the same period, into each option. The table below looks at the first five years of the mortgage above. In one column, 200 a month is overpaid. In the others, the mortgage runs as normal and 200 a month goes into savings at an illustrative after-tax rate, compounded monthly, with each deposit made at the end of the month.

After five years, the overpayment route has a mortgage balance of 163,559.17 instead of 177,160.37: a difference of 13,601.20. That is the 12,000 overpaid plus 1,601.20 of interest that was never charged. The savings route has the full balance still owing, but a savings pot to show for it.

In this scenario the break-even point is simple: when the savings rate after tax equals the mortgage rate, the two routes leave you equally well off on paper. Below that, overpaying comes out ahead; above it, saving does. You can model the savings side for any rate, term and contribution in the compound interest calculator, or work backwards from a target in the savings goal calculator.

The numbers are only part of the decision. The two routes differ in ways a table cannot capture: how easily the money can be reached, what happens if rates change, and what charges apply. The rest of this guide covers those.

Tax on savings interest

The savings rate that matters is the one left after tax. In the UK, interest is taxable income, but a Personal Savings Allowance lets basic-rate taxpayers receive up to 1,000 pounds of interest a year tax-free and higher-rate taxpayers up to 500 pounds, while additional-rate taxpayers get no allowance. Interest above the allowance is taxed at your usual income tax rate, and some people with low other income can also use the starting rate for savings. Tax-free wrappers such as ISAs have their own rules.

In the US, the IRS treats most interest credited to an account you can withdraw from without penalty as taxable income in the year it becomes available, including interest on bank accounts, money market accounts and certificates of deposit. Other countries have their own rules and allowances.

To convert a gross rate into an after-tax rate, multiply by one minus your marginal tax rate on interest. A 3.75% gross rate taxed at 20% becomes 3.00% after tax, which in the table above puts saving 671.86 behind overpaying after five years. If your interest falls within a tax-free allowance, the gross and after-tax rates are the same.

Early repayment charges and overpayment allowances

Lenders can charge for paying back early, and the rules differ by country.

• United Kingdom. Many fixed-rate and discounted deals carry early repayment charges. FCA rules require these charges to be expressible as a cash value and to be a reasonable pre-estimate of the lender’s costs from the early repayment. Allowances of up to 10% of the balance a year without a charge are common, but the percentage, the 12-month period it runs over and how the balance is measured are set by each lender.
• Canada. The FCAC describes a prepayment privilege as the amount you can pay on top of regular payments without a prepayment penalty. Penalties for paying more than that, or for breaking the mortgage, are commonly the higher of three months’ interest or an interest rate differential, and can run to thousands of dollars.
• United States. The CFPB explains that prepayment penalties, where a loan has one, usually apply to paying off all of the mortgage within a set period, often the first three to five years, and do not normally apply to small extra principal payments.

Access to the money

Liquidity is often the deciding factor that the arithmetic leaves out. Money in an instant-access savings account can be withdrawn for a car repair, a job loss or a medical bill. Money overpaid on many mortgages cannot be taken back without remortgaging or borrowing in some other way, which may not be possible at the moment it is needed, and which may cost more than the mortgage rate.

That is why the order matters. A common approach in financial education is to hold an emergency fund before committing spare money to anything that cannot easily be reversed. How large that fund needs to be depends on your income stability, household and commitments, and the savings goal calculator can show how long it would take to build one at a given monthly amount.

Some mortgages include features that let you borrow back overpayments, take payment holidays or offset savings against the balance. Their terms differ widely, so the only reliable source is the product’s own documentation.

Other things that change the answer

• Other debts. If you also have credit card or personal loan debt at a higher rate than the mortgage, overpaying the mortgage reduces the cheapest debt first. Our guide to the debt avalanche and snowball shows how rate ordering affects total interest.
• Rate changes. When a fixed rate ends, the mortgage rate may rise or fall, and savings rates move too. A comparison that holds today may not hold after a remortgage.
• Loan-to-value bands. A lower balance can move a mortgage into a lower loan-to-value band at remortgage time, where rates offered are often different. This depends entirely on the lenders and market at the time.
• Pension contributions and employer matching. In some countries, contributing to a pension can attract tax relief or employer contributions, which changes the comparison considerably. These rules are country-specific.
• Inflation. A fixed mortgage balance shrinks in real terms as prices rise, and savings lose purchasing power if their after-tax rate is below inflation. Both routes are affected, which is why the comparison above uses money amounts rather than real values.

Running your own numbers

To compare the two routes for your own situation:

1. Enter your balance, rate and remaining term in the mortgage calculator, add a regular overpayment, and note the balance after your chosen period and the interest saved.
2. Enter the same monthly amount, the same period and your after-tax savings rate in the compound interest calculator.
3. Compare the reduction in mortgage balance with the savings pot, then weigh up the non-numeric points: charges, access to the money and how long each rate is likely to last.

All of our assumptions, including how interest is rounded each month and how overpayments are applied after the scheduled payment, are described on the methodology page.

This guide explains how things work in general terms. It isn’t financial, tax or legal advice. Spotted something out of date? Email errors@moneyotter.com and we’ll check it against the source.