Money clinic: When does it make sense to overpay on a mortgage?

Overpaying on your mortgage will always reduce how much you shell out in interest in the long run.

My mortgage allows overpayment of 25 per cent of the remaining balance without penalty. It also allows reducing the loan period without penalty. I have a variable-rate product linked to Eibor currently costing me about 4 per cent. With the Fed funds rate likely to tick up this year should I overpay or reduce the loan period? And should the likely trajectory of interest rates influence that decision? MM, Dubai​

Expert 1: Jean-Luc Desbois, the managing director of Home Matters Mortgage Consultants

If you have no planned short- or long-term cash requirements for the surplus funds, you may want to pay down the loan, as you are unlikely to receive 4 per cent on your deposits any time soon. However, if you are likely to have capital requirements in the future for school or university fees, travel, relocation, automobiles or renovation, sit tight.

It is important to maintain an adequate cash reserve or rainy day fund, particularly if there is any possibility of changes in circumstances.

Although interest rates have gone up and are likely to increase later this year, we do not anticipate them rising to significant levels in the short term. As the saying goes, “cash is king”, so ensure you have adequate liquidity which in turn provides flexibility and options. The lessons of the past 10 years are not to over-commit or be too heavily invested in one asset or asset class. Remember, 4 per cent is still a good rate. If and when rates increase, start phasing the extra payments in to keep the monthly repayments at manageable levels.

Finally, I recommend maintaining mortgages over the maximum term available for most borrowers. If you have to leave the property or country, the mortgage repayments should be covered by any rental income. You can always reduce the outstanding amount with top-up payments. This provides you low monthly fixed commitments with greater flexibility and control.

Expert 2: Lukman Hajje, the chief commercial officer of propertyfinder.ae

Yes, rates are tipped to increase this year and have already done so in some instances. Emirates NBD raised its rates significantly just before the new year and mortgage rates in general are not as attractive now as they were just two to three months ago. Having said that, they are still very attractive and low by historical standards.

In an environment where rates are likely to increase it is tempting to fix your rate for one to five years, but be aware that fixed rate loans offer less flexibility and may incur additional break costs should you want to get out of them.

Regardless of whether or not rates increase, if you can afford to pay extra on your mortgage without penalty it makes sense. Making additional payments while maintaining your regular monthly repayments automatically reduces the term. The additional lump sum repayment will save you at least 4 per cent, which is probably over 3.75 per cent more than it will earn sitting in your regular bank account. Each year, however, this saving compounds and the saving grows exponentially. For example a Dh1.5 million mortgage over 25 years at 4 per cent will cost Dh7,977 per month. If you were able to pay an additional lump sum of 25 per cent of the total loan amount (Dh375,000), you’d save Dh473,392 in interest and reduce your loan term by almost nine years. If you don’t have this kind of lump sum, the numbers still look attractive. A 10 per cent lump sum payment reduces your interest by over Dh226,000 and enables you to pay off your mortgage four years sooner.

Another strategy could be to increase your monthly repayments. In this above example, an extra Dh1,500 per month would reduce the loan term by six years and save Dh233,003 in interest.

Next question:

Is your end-of-service gratuity based on the basic component of whatever your final salary is? Or is it based on a combination of what your basic salary was before your contract was changed plus what your basic salary was after it was changed? GM, Dubai

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