This pay rise trick can prevent £20,000 in your mortgage: Here’s tips on how to make it be just right for you

Homeowners who need to remortgage this year may well be feeling concerned. 

Rates have surged since the war in the Middle East began. At the start of March, the lowest two-year fix for a remortgage was 3.62 per cent from Santander and for a five-years fix it was 3.79 per cent from first direct. 

Currently, the lowest two-year fix is 4.79 per cent from NatWest and the best five-year is now 4.75 per cent from Nationwide Building Society.

A homeowner with a £400,000 home and £200,000 mortgage might have paid £1,172 a month if fixing for two years with a 20 year repayment term at the start of March.

Today, that same homeowner would be looking at paying at least £1,297 a month.

Short-term rate rises can’t be avoided. However, new number-crunching has shown how homeowners could save themselves tens of thousands in the long term – and pay off their mortgage faster – by increasing their payments each time they get a pay rise.  

How does it work?

The analysis carried out by Coventry Building Society reveals that borrowers with a £200,000 mortgage could save £20,081 in interest by raising their monthly repayment by just £35 – about £1.17 per day.

This is equivalent to increasing their payment in line with the long-term average wage rise of 2.9 per cent.

Someone with a larger mortgage could save even more, as the table below shows. A borrower with a £500,000 loan who increased payments by £88 each month would cut their interest bill by £50,203 over 20 years.

‘Overpaying on your mortgage is worth doing if you can afford to because you clear the balance earlier and pay less interest in the long run,’ says Mark Harris, chief executive of mortgage broker SPF Private Clients.

‘The advantage of channelling a pay rise towards mortgage overpayments is that you won’t miss it as such, as you never had it in your pocket in the first place.’

 Homeowners can overpay their mortgage by making an extra payment – on top of their usual monthly one. 

This can shorten the length of their loan term, and reduce the total amount of interest they will pay over the years.

How much can you overpay your mortgage? 

Most fixed-rate mortgage deals allow borrowers to make overpayments amounting to up to 10 per cent of the total outstanding amount each year.

But any more than this and they may be slapped with an early repayment charge, which would cancel out the benefits of overpaying. 

With many households under pressure from higher interest rates and rising living costs, large lump-sum overpayments will likely feel out of reach. 

But this simple ‘pay rise matching’ technique demonstrates that small, manageable increases can compound into substantial long-term gains.

‘Most people think you need to make big overpayments to make a difference – but that simply isn’t true,’ said Jeremy Cox, head of strategy at Coventry Building Society.

‘Increasing your payments in line with a typical annual pay rise works because even small early increases chip away at the balance faster. 

‘A £35 increase on a £200,000 mortgage might not be too noticeable each month, but over time the impact is dramatic. 

‘It’s one of the simplest, most effective financial habits homeowners can adopt in the current high‑rate environment.’

How to make the ‘pay rise matching’ hack work for you

1) Compare savings rates against your mortgage rate

To make sure this strategy works as effectively as possible, homeowners may want to first compare their mortgage rate with their savings rate.

This is because overpayments deliver the best value when a person’s mortgage rate is higher than what they can earn on savings after tax. 

This will be a tall order right now given that the best mortgage rates are trending just below 5 per cent at present. 

However, for those still on a lower fixed rate deal between 1-2 per cent that was taken out four or five years ago, they will likely be better off saving.

The best easy-access cash Isa, from which you won’t have to pay tax, is currently offered by Plum at 4.6 per cent. But there are plenty of other good options. Check out the best cash isa rates here.

Ray Boulger, senior mortgage technical manager at broker John Charcol says: ‘Over 4 per cent can be earned on Isas. Anyone who has a mortgage rate below this would be better off saving spare cash in an Isa.

‘If their mortgage rate increases after the current fixed rate ends, an option would be to use the Isa savings to overpay the mortgage at that stage.’

Those saving outside an Isa currently get the first £1,000 of interest tax free if they are a basic rate taxpayer or £500 if they are a higher rate taxpayer. 

Right now, the best easy-access savings rate is the Cahoot sunny day saver account which pays 5 per cent on anything up to £3,000.

A better option could be a regular savings account, which allows people to put aside a relatively small amount of money each month with a higher rate. However, these typically require setting up an account with a particular bank.

Zopa Bank currently offers a 7.1 per cent regular saver, though you’ll need to sign up to its Biscuit current account. First Direct and Co-op bank also offer 7 per cent rates.  

2) Clear other debts first 

If you have credit card or overdraft debt or personal loans, it’s usually better to clear this before overpaying your mortgage.

That’s because these debts tend to come with higher interest rates attached and therefore should take priority.

3) Don’t pay off your mortgage using your emergency savings

Everyone needs money in reserve for any unforeseen costs, so don’t pay down your mortgage at the expense of your rainy day fund.

Having three months to six months of essential expenses in easy-access savings provides extra peace of mind.

Harris says: ‘It is always worth building up a rainy day fund as well to cover unexpected expenses such as a new boiler or car repairs, as money overpaid on the mortgage can be very difficult to get back again.’

4) Prioritise essential living costs before the mortgage

The cost of living has risen dramatically in recent years with food and groceries costing more. And thanks to the conflict in the Middle East, energy prices are set to rise again.

Harris says: ‘Even if you are in receipt of a pay rise, chances are it will go towards higher cost-of-living expenses, such as rising energy, fuel or food bills. 

‘These should take priority over extra mortgage payments as they are short-term essentials which you don’t have much say in paying.’

5) Pay into your pension before paying off your mortgage 

Taking advantage of pension tax relief and employer contributions is still one of the most valuable long-term financial habits, alongside overpaying a mortgage.

Workplace pensions where contributions are matched by the employer are likely to be the starting point for most retirement savers. For example, where you put in 5 per cent of your salary, your employer may match it and also pay in 5 per cent.

Those that don’t have a workplace pension scheme can do it alone using a Self Invested Personal Pension (Sipp).

It doesn’t require someone to save up tens of thousands pounds to get started and many investing platforms will allow customers to pay in a direct debit each month.

There is also the immediate benefit of pension tax relief when paying into a pension, up to £60,000 a year.

When someone pays into their pension, the government adds at least 20 per cent in pension tax relief to their contribution.

Higher or additional rate taxpayers can then claim their full 40 per cent to 48 per cent tax relief through their tax return. 

‘Most employed people will see their pension contributions increase in line with any increase in salary, but those whose pay increase takes them into the 40 per cent tax bracket will see extra value in increasing pension contributions,’ says Ray Boulger.

‘This will be even more relevant for anyone with children whose salary increase takes them above £60,000, where they start to lose child benefit, or anyone going above £100,000 and hence into an effective 60 per cent tax bracket.’

6) Factor in tax on any pay rise

Ray Boulger of broker John Charcol suggests that those who wish to put this technique into practice, need to factor in tax first.

He says: ‘Although many people will receive a pay rise this month, in particular following increases in the various minimum wages and real living wage, the net increases will be less than the gross because of fiscal drag, with tax thresholds remaining unchanged.

‘Of those who get a pay increase very few will have an average increase anyway and so any mortgage overpayments need to be based on individual circumstances rather than an average.’