Who is overpaying their mortgage and why?
Published: 13 December 2012 | Author: Bernard Clarke
Last week, the Bank of England again left the base rate unchanged at 0.5% – at an historically low level at which it has remained for almost four years. Such a low rate presents borrowers with greater potential to overpay their mortgage, enabling them to save on interest payments overall and pay off their mortgage early. But are borrowers taking advantage of lower rates to pay down debt?
In July 2007, the base rate stood at 5.75%, and the average rate on outstanding variable rate mortgages was 6.42%. As the financial crisis took hold, however, the Bank of England aggressively cut the base rate, eventually to 0.5% in March 2009. As a result, borrowers on variable rate mortgages – and, in particular, those on bank rate trackers – have seen their interest payments fall significantly.
The extent to which individual borrowers have benefitted from the low base rate depends on what type of mortgage they took out, and when. Borrowers on variable rates saw immediate benefits, while those on fixed-rate mortgages were initially unaffected. But a significant majority of those on fixed rates reverted to a lower rate when their original agreement came to an end, as CML research has shown.
Interest rates and capital payments
For the majority of borrowers with repayment mortgages, the amount of capital they pay back each month rises automatically when interest rates fall. For example, the monthly payments on a repayment mortgage with an outstanding balance of £100,000 and 20 years left to run would fall from £660 a month to £506 if the rate of interest applied to it fell from 5% to 2%. Within this lower overall payment, however, the amount of capital repaid each month would rise from £243 to £339.
One-third of borrowers since 2005 have overpaid their mortgage
Most mortgages also have an option enabling the borrower to overpay capital (sometimes with an annual limit) without incurring any charge. Doing so enables the customer to pay off his or her balance sooner than would have otherwise been the case. When falling interest rates lower the total monthly payments due on the mortgage, some borrowers may choose to raise their capital repayments further - for example, by maintaining their total payment at the same level as before the rate cut.
In our example, if the borrower elected to keep his or her total monthly payment fixed at the £660 due before rates fell, the amount of capital repaid each month would rise further still – to £493 a month. If this payment schedule was maintained and there were no further rate changes, the mortgage would be paid off in less than 15 years.
Capital repayments can be split into three main categories – mortgage redemptions, regular scheduled repayments (as in our example), and ad hoc lump sum payments. Of these, redemptions account for the majority of the total. The main drivers of redemptions are house purchase activity (when home movers redeem the mortgage on their previous property) and remortgaging. With both of these running at historically depressed levels, redemptions, too, have been flat since 2009 – at around 7% of total balances outstanding per year. This is well under half the average over the preceding 10 years.
The other two categories of capital repayment – regular monthly and lump sum payments – can be thought of collectively as "within-term" capital payments. But as Chart One shows, there is nothing in published data to indicate that borrowers in aggregate have been paying down more of their mortgage debt within term.
Chart One: Within-term mortgage repayments, % of outstanding mortgage stock
We must not forget, however, that aggregate figures conceal a wider range of individual consumer behaviour. So, what does the data from our regulated mortgage survey (RMS) tell us about the extent to which individual borrowers have been choosing to pay down debt? And what does it say about the type of borrowers who have been doing so?
RMS data is collected at point-of-sale only but, by using a sample of loans in which we know more about subsequent payments, we can track what has happened to payments from origination up to March this year. This data allows us to identify individual loans where the balance remaining at that point was less than expected had the borrower only made his or her contractual payments. If the amount outstanding is lower than this, it implies that the borrower has made additional "within-term" repayments.
It is important to understand that, while this data is reasonably accurate, it is illustrative, rather than precise. To avoid overestimating the number of borrowers overpaying, we have therefore only counted as overpayments those cases in which capital repayments exceed 5% of the expected paid-down balance.
Table One shows how we estimate that, between April 2005 and March 2012, some 2.3 million borrowers had paid off more than the contractual amount. Leaving aside loans repaid in their entirety, this equates to around 34% of all mortgages taken out in that period.
The £31 billion overpaid since 2005 is a sizeable accumulation of household wealth
It is important to emphasise that our methodology takes account of the fact that lower rates automatically increase capital repayments, as our earlier example shows. So, we do not classify borrowers who are making increased repayments only because of this effect as having made overpayments. Only those paying more than the automatically increased capital repayment are flagged as being ahead of schedule.
Table One: Borrowers overpaying on their mortgage, March 2012
Previous research undertaken by Policis for the CML showed a wide range of behaviour by borrowers experiencing lower interest rates. Many have used the "wriggle room" created by lower mortgage rates to pay down more expensive unsecured debt or, in difficult economic conditions, to absorb additional pressures on household budgets. Despite this, however, we estimate that mortgage borrowers cumulatively have been able to overpay to the tune of more than £31 billion – or about 10% of a total £315 billion of "within-term" capital repayments made in the period.
Who is paying down capital – and why?
For the most part, the proportion overpaying their mortgage does not vary much over time. The significant exception to this is among borrowers taking out mortgages in 2008 and, to a lesser extent, 2009. A significantly greater proportion of these borrowers have made accelerated payments. That is what we might expect, given that the bank rate was at 5% or higher until October 2008 and that tracker mortgages – which, at that point, were typically priced at less than 100 basis points over bank rate – accounted for nearly a third of new lending. These data also show that overpayments are not evenly distributed. Some borrowers are more likely to have overpaid than others. Chart Two shows some of the key features of those borrowers who have overpaid. Not surprisingly, overpayments are much more common among borrowers with tracker mortgages than those with fixed-rate loans. Overpaying borrowers are more likely to have borrowed at lower loan-to-value (LTV) ratios and income multiples. And, as shown in Table One, a significantly higher proportion of loans originated in 2008 have been overpaid, compared to other years.
Chart Two: Proportion of borrowers making overpayments, by borrower segment
Borrowers with offset mortgages are significantly more likely to have overpaid but this, too, is not surprising. The ability to pay off the mortgage faster is a key selling point of offset products, so it is encouraging that borrowers are using them for this purpose. But it is also likely that the pattern of overpayments reflects the fact that nearly all offset mortgages have variable rate mortgages, enabling borrowers to pay off additional capital partly as a result of lower rates overall.
The £31 billion of overpayments on mortgages originated since 2005 is a sizeable accumulation of household wealth. But there is a wide distribution in the individual amounts repaid. Half of all overpaying on their mortgage have done so by £5,000 or less. But there is also a sizeable number making significantly larger overpayments, with 10% overpaying by more than £20,000.
It is also revealing to look at the extent to which individual borrowers have reduced their LTV ratio through overpayments. Chart Three shows that those with lower LTV ratios at the outset have been able to make the greatest reductions, with those at higher initial LTV ratios reducing their debt more modestly.
Chart Three: Reduction in LTV by overpaying borrowers
The slashing of interest rates to their current historic low point has helped many borrowers make additional capital repayments. In doing so, they have built up a bigger equity stake in their property – and reduced the impact on their finances of any subsequent rate increases. They will also have increased the likelihood of being mortgage-free sooner than anticipated, all of which increases their options should their financial circumstances deteriorate.
The capacity of borrowers to pay down capital and become mortgage-free sooner than expected may compound a trend recently highlighted by Hometrack, which could mean that there are more outright owners than mortgage borrowers by 2014 or 2015.
Rates look set to remain at their current low level for some time yet, meaning there is further potential for mortgage debt to be repaid ahead of schedule. That does not necessarily mean that it will be. With household budgets increasingly stretched by a combination of inflation, sluggish wage growth and welfare cuts, more of the "windfall" of lower payments may be drawn upon to meet other household commitments. But overpayments, where they are made, will ease the pressures on household finances.