A person signing on to a new home loan might expect to be paying it off for the next 30 years - that’s a long time for interest to accumulate. A big way to mitigate that interest bill is paying extra - if your mortgage allows for it.
Whether you overpay by $20 a week or you sink your annual bonus into the facility as lump sum repayment, paying back more than you’re required is the best way to reduce the length of your mortgage and, therefore, the amount of interest you’ll pay over its life.
Should you overpay your mortgage?
The regular repayments on a principal and interest home loan is divided into just that - principal and interest portions. The interest is charged by your bank or lender and is based on each dollar outstanding on your mortgage. So, if you repay some of those dollars early, then you’ll no longer be paying the bank for the pleasure of borrowing them.
Anything you pay on top of your regular repayments goes towards paying down the principal balance of your home loan, thereby knocking out dollars before they’ve had a chance to generate any more interest. Thus, if you can make overpayments of any size, whether on the back of a bonus at work, a windfall, or using money that would otherwise go towards takeaway coffees, you'll reap long-term rewards.
By how much might you be able to benefit from extra repayments? Find out by using InfoChoice’s Extra Repayments Calculator. It can give you a good idea as to how even modest overpayments can build up over the years, potentially saving a borrower tens of thousands of dollars.
However, there are instances in which it mightn’t be wise to make extra repayments on your home loan. For instance, if you had high-interest consumer debt, such as credit card debt, it’s probably worth paying that down before overpaying on a comparatively lower-interest loan such as a mortgage.
Can you overpay your mortgage?
So far, so good. Make some overpayments and you'll be mortgage-free earlier, right?
Not necessarily. Not all mortgage lenders allow for overpayments and some limit how many extra repayments you can make. That’s typically the case for fixed rate mortgage products.
Fixed rate home loans can provide peace of mind, as a borrower will always know how much their next repayment will be. But, as a bank or lender will generally borrow the money that it lends to a person with a fixed rate loan, if a person were to pay their fixed rate home loan back earlier than planned the bank or lender might end up out of pocket.
On that note, if your overpayments reduce the term of your mortgage to nothing, you may incur a break fee. Break fees can be significant. Their size is generally determined based on the loss incurred by the lender on the cessation of its agreement with a borrower.
Variable rate mortgages tend to be more flexible than fixed rate products when it comes to making early repayments and overpayments. Still, it's important to find out how extra payments will impact your personal situation.
Will overpaying reduce my regular home loan repayments?
Short answer: No. Making repayments above and beyond those demanded by a bank or lender won’t reduce the value of future repayments. However, as your principal balance becomes smaller thanks to your efforts, so will the interest component of your repayments. So, if you were to overpay regularly, you will shorten the life of your loan.
Further, some banks will allow borrowers to dip back into their extra repayments to take a ‘repayment holiday’ without extending their home loan’s lifespan. Thus, if you’ve made plenty of extra repayments over the life of your loan and find yourself in turbulent financial waters, you might be able to lean on your previous, proactive payments.
Example: How overpayments reduce the life of a home loan
Imagine you have a new mortgage of $400,000 at an interest rate of 5% p.a. to be paid over 30 years. The monthly repayments are around $2,147 without any overpayments, according to InfoChoice's Home Loan Calculator.
If you find yourself in such circumstances and decide to overpay by just $20 each month, you'll likely shave seven months off of your mortgage and save approximately $8,445 in interest.
A larger overpayment of $100 each month would probably mean you'd be mortgage-free two years and eight months early and save more than $38,200 in interest. Crikey.
What’s the best way to overpay your mortgage?
You might not be in a position to make hefty extra repayments right from the birth of your home loan. But then again, squirreling away smaller amounts in order to make a larger lump sum a few years down the track likely isn’t the best way to overpay your mortgage.
Remember, as soon as those dollars are wiped from the balance of your mortgage, they stop generating interest. So, you might find that the sooner they're gone, the better.
Making a big lump sum repayment towards the end of your mortgage will shorten the life of your loan, but you will have already paid a large amount of interest by that point. While lump sums can have a huge impact, if you don't expect to be able to make one any time soon, it’s probably more worthwhile to carry on making smaller overpayments.
Thus, the best way to overpay your mortgage might turn out to be putting a small, additional sum on top of your regular repayments, even if all you can spare is $5 a month.
Increase the frequency of your payments
Some home loans will let you change the frequency of your repayments from monthly to fortnightly, or even weekly, which reduces your interest burden and the length of your mortgage.
Changing to fortnightly payments will generally mean that you make 26 payments each year, rather than the 12 you would make paying monthly. By doing the math, we can see that by paying fortnightly a borrower makes an additional month’s worth of repayments (roughly) each year.
Therefore, paying fortnightly can mean a borrower repays their home loan back sooner than they otherwise would if they were paying monthly. Also, as interest is calculated on a daily basis, making more frequent repayments reduces the balance on which interest is charged more regularly, thereby depriving your interest rate a balance in which to attach itself.
Most home loans allow you to redraw overpayments
There may come a time when you might need that $15,000 windfall you paid into your home loan. You might decide to renovate your kitchen, for example, or install solar panels.
Most mortgage products will allow you to redraw any overpayments you've made over the course of your home loan. That means you can access some or all of the cash when you need it. Do remember, however, that your outstanding balance will be increased and you'll add back some of the months or years you shaved off by making the extra repayments in the first place.
If you’ve considered all the above information and still find making extra repayments on your home loan nerve wracking, then an offset account might be more up your alley. Money stored in an offset account is normally ‘offset’ against your borrowings, meaning your home loan repayments won’t include interest on the value of cash kept in the easily accessible account. Though, offset accounts normally incur fees and many of the market’s most competitive home loans generally don’t offer offset accounts.
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Originally published by Natasha Poynton on 21 October 2020, updated by Brooke Cooper on 30 October 2023.