Paying a debt early saves less when the interest was charged upfront

This is less a set of instructions about early repayment than an argument, and it is worth saying so at the start.

Two ways interest is calculated

Most modern loans and mortgages accrue interest daily or monthly on the outstanding balance, so reducing the balance reduces interest from that day. Some consumer agreements instead calculate the total interest at the outset and add it to the amount owed, producing a fixed total repayable. In the second case, paying early does not automatically avoid interest, because it was already charged.

Which method applies is stated in the agreement and determines whether overpayment is worth anything.

Rebates and how they are calculated

Consumer credit rules in many jurisdictions require a rebate of unearned interest when an agreement is settled early. The formula used to calculate that rebate is set by regulation and frequently favours the lender relative to simple pro-rating.

Practically, some regimes historically allowed methods that allocated a disproportionate share of interest to the early months, meaning early settlement saved less than expected. The consequence is that the saving from settling early can be materially smaller than the remaining scheduled interest.

Ask for the settlement figure in writing

Lenders must generally provide a settlement figure valid for a stated period, showing exactly what clearing the debt today would cost. Comparing that figure to the sum of remaining payments gives the actual saving, with no estimation involved. Doing this before making a decision avoids relying on assumptions about how the agreement works.

The figure also reveals any early settlement fee, which some agreements charge separately.

Overpayments versus settlement

Partial overpayment behaves differently from full settlement, and some agreements permit one and not the other. Where overpayments are allowed, ask whether they reduce the term or the monthly payment, because the interest saved differs substantially between the two. Reducing the term saves more interest; reducing the payment improves monthly cashflow.

Lenders sometimes apply one by default, and switching usually requires an explicit instruction.

Where the money should go instead

Overpaying a low-rate debt while carrying a high-rate one costs money, and the ordering is simple arithmetic. Overpaying any debt while holding no emergency buffer risks having to reborrow at a worse rate after the next surprise. Where the debt rate is below what savings earn after tax, the arithmetic can favour saving instead, though certainty and psychology also matter.

The rates involved change, so this comparison needs redoing rather than deciding once.

Assume any product feature can be withdrawn at renewal.

Charges that apply on the way out

Mortgages and some fixed-rate loans carry early repayment charges expressed as a percentage of the balance, often tapering by year. Many allow overpayment up to an annual limit without charge, which is the mechanism most overpayers should be using. Exceeding that limit can trigger a charge that exceeds the interest saved.

The permitted amount, the charge and the calculation method are all in the offer document and worth checking before the first overpayment.

The takeaway

Get the settlement figure and the overpayment rules in writing before assuming early repayment saves what it looks like it saves.

Costs compound as reliably as returns do, and in the same direction.