The benefits of making a lump sum payment on your mortgage

ANALYSIS: With interest rates on the up, it’s worth investigating how you can start to make extra payments on your mortgage to be prepared for the increased payments in the future. This has two main benefits: there is less impact when your fixed rates eventually mature from the previous low rates; and, in the meantime, you are paying your mortgage down thereby reducing the amount of interest you will pay in the future.

Most banks allow some additional payments on a mortgage without any penalty, even after an account has been fixed. This provides some flexibility that a lot of homebuyers don’t realise they have. A pay rise could be put straight onto the mortgage and mean large long-term savings.

When you are refixing your mortgage you can set your payments to be whatever you like, as high as you like - with no penalties. There’s an important side note here, though; any time you commit to a regular payment on your mortgage you will need to apply to the bank to lower those payments to the minimum again. You’ve locked in those payments until the end of the fixed term.

Because increased payments are locked in until the end of the fixed term, it’s usually recommended the extra payments are on your shorter-term accounts as a lot can happen in three to five years.

Some banks give you a couple of options for making additional payments on your mortgage. They allow you to either pay off the mortgage in a lump sum or increase your regular payments. Typically, as long as either doesn’t result in you paying more than 5% off your mortgage per year, there are no or very minimal additional fees (although there can be a small admin fee).

Let’s say you have a mortgage of $500,000 that you have fixed for a year and, after one month, you receive a bonus of $25,000 (so 5% of your mortgage that you can pay off without penalty). Is it better, from a financial perspective, to pay your mortgage off in a lump sum or increase your regular payments?

MortgageLab founder Rupert Gough: “More regular income such as a pay increase would usually be put to better use via increased mortgage payments.” Photo / Fiona Goodall

To answer this question, it helps to remember that your mortgage has the interest added to it daily. With that in mind, it becomes a bit clearer which is the better option. Paying the $25,000 off as a lump sum immediately reduces your mortgage by that much, meaning you are paying interest for the remaining 11 months on approximately $475,000 (minus any principal that was paid in that first month) whereas regular increased payments (a little over $2,000 per month) would slowly reduce your mortgage over the year meaning less overall savings.

A very basic rule of thumb for deciding whether to increase mortgage payments versus make a lump sum payment onto your mortgage is to match how the money is being received. If you are receiving a large sum of money - a bonus or inheritance - it would typically be better to pay this as a lump sum onto your mortgage. More regular income such as a pay increase would usually be put to better use via increased mortgage payments. As with all these types of decisions, however, run it by your bank or adviser to make sure there aren’t better options out there for you.

- Rupert Gough is the founder and CEO of Mortgage Lab and author of The Successful First Home Buyer.