There is an easy way to illustrate the impact of mortgage interest on people’s finances. Imagine that instead of receiving income in regular pay packets, everyone was given a ‘money tree’ at birth covered with £5 note leaves whose value amounted to an entire life’s income.
Would anyone get a mortgage in this world? Of course not, they would simply pick the amount of money they needed off the tree whenever they needed it. Consequently, they would never pay interest on a debt because they would never need to be in debt ‘ so long as major purchases could be covered with enough spare to cover a lifetime of day-to-day spending, the amount needed would just be plucked off the branches.
A fanciful thought but one that gets us back to the basics. No-one has a money tree, we earn our lifetime’s income in small chunks and, as a result, whenever we want to buy something that costs more than we have, we either have to save, or borrow. Ownership can be deferred until we can afford to buy outright or we can take ownership now and defer payment. Most of us prefer the latter route because the need for a home is usually immediate. So, if we choose to borrow, the penalty we pay is interest ‘ in effect a convenience charge for being allowed to manage long-term debts down into bite-sized chunks. Interest does not help anyone own their home ‘ it simply allows them to buy it.
A matter of convenience
If we could stand back and look at our total mortgage interest bill in money tree terms, we would note that it is one of the largest items of our lifetime’s expenditure but also one of the few that buys us, quite literally, nothing but the convenience of ownership before we can really afford it. This is, of course, important but once you look at the figures the picture becomes quite alarming.
A homebuyer taking out an interest-only mortgage on a £90,000 property at 6.2% over 25 years, will find that their total lifetime interest bill amounts to £139,500 before they have paid off a penny of the capital debt. In effect, when their endowment matures and they settle the debt in full, they will have paid 255% of the amount they originally borrowed. Repayment mortgage customers pay a lower proportion of interest ‘ some £87,000 ‘ but this is still 89% of the original loan.
Back in the days of prolonged high inflation in the 1970s, the retail price index was hitting growth rates of over 10% a year. This lengthy interest burden was actually an advantage, because the falling value of money in real terms reduced both the true value of the underlying debt and the burden each month of the interest payment. Effectively, your debt stayed fixed while your wages went up. The real value of a £25,000 mortgage debt taken out in 1974 would have reduced to just over £12,000 in just five years ‘ a reduction of more than 50%, making inflation a stronger reducer of capital debt than the homeowner.
Today, the picture is very different. Inflation is running consistently at less than 2% per year. In this climate, it would take over 30 years for inflation to cut the real value of a long-term debt in half. Put simply, in a low inflation environment, a long-term debt is the worst bet.
The beauty of the flexible mortgage ‘ pioneered in Australia ‘ is that it frees the holder to manage their mortgage balance down faster than the standard 25-year formula that most lenders use. Extra funds can be ploughed in through overpayments and, as the underlying debt is reduced, the monthly payment may only come down marginally, but the overall interest bill can be cut dramatically.
This is particularly true for people at the beginning of a repayment mortgage, where every £1 of overpayment will save interest on that £1 every month for up to 25 years. Although homeowners are making consistent payments each month, the greatest part of these mortgage payments goes on servicing the debt through interest during the early years. Only a small proportion is actually set against the debt to reduce it. Towards the end of the mortgage, the reverse is true, but by this time in interest terms, the damage has already been done.
Flexible lenders need to package the ability to overpay with two other benefits to ensure customers can get the most from their flexibility: daily interest calculation and no early redemption penalties.
Daily interest calculation was introduced in Australia almost 20 years ago, which means homeowners never pay interest on money they no longer owe. The interest charged on the debt reduces with every capital payment ‘ whether it is a regular monthly payment or a lump-sum overpayment.
Today in Australia, all lenders charge interest in this way, but despite recent encouraging shifts by major lenders it is estimated that over 60% of people in the UK are still paying interest which is calculated annually. This means any repayments made during a year have no effect on the interest charged until the ‘calculation anniversary’.
Likewise, the benefits of overpayment can be negated if the lender imposes any penalty on partial or full early redemption. For true control ‘ where the homeowner manages the debt rather than vice versa ‘ there should be no barriers to capital payments.
Regular overpayments are the holy grail of interest saving because the homeowner can plan a consistent monthly payment which reduces their long-term outgoings significantly and also cuts the term of the loan. With a larger £130,000 repayment mortgage at 6.2% a £50 overpayment each month cuts almost £19,000 off the interest bill and 37 months off the term. Increasing this to a £200 per month overpayment would cut a massive £49,000 of interest and help to pay off the loan almost eight years early.
Once customers are in a position to assert control over their debt, there are other money saving tricks which can make a difference.
Where lenders will allow payments to be made more frequently than monthly, customers who make fortnightly payments which are the equivalent of half their normal monthly payment can effectively squeeze an extra month’s overpayment into each year because there are 26 fortnights but only 12 months.
Likewise, by making a ‘first day’ capital payment on the very opening day of their mortgage term, rather than waiting for up to 60 days to start the reduction of the mortgage debt, homeowners can turn a £200 payment into a £400 interest saving.
There are also potential tax savings to be made by setting savings off against a flexible mortgage, rather than depositing them in an account, where the interest rates earned are usually 1%-2% lower than those paid on a mortgage with returns taxed.
As mortgage overpayments save interest that would have otherwise been paid to the lender, the savings are not taxable. This makes the effective return on an overpayment the equivalent of untaxed savings at mortgage rates.
In the days when capital repayments were strictly ‘one way’ this was only appealing if the money used to reduce the debt could be written off. Today, however, many flexible mortgages allow customers to draw back previous overpayments, which makes such overpayments highly tax efficient and highly interest efficient while remaining accessible.
Overall, the rise of the flexible mortgage is a ticket to a wide range of potential savings for homeowners who either have spare cash each month, or else bonus lump sums arriving periodically. Flexible products break the shackles of fixed term, fixed debt loans and turn debt into a manageable feature within a household’s commitments.
Some commentators have gone so far as to predict that the huge upsurge in interest in flexible finance may spell the end of the traditional mortgage within years. For anyone who looks out into their garden and tries to imagine how life might be if a money tree grew there, it may not be a moment too soon.
Regular overpayments can save thousands in interest and reduce the term of the loan.
Lenders must calculate interest daily and charge no redemption fee if overpayment is to be effective.
Making fortnightly payments enables clients to squeeze an extra month’s overpayment into the year.