Overpaying a loan: shorten the term or lower the payment?
The bank asks which one when you make a lump-sum overpayment. The choice changes the saving several times over, and the bank's default is rarely the better one.
You overpay a loan with a one-off amount. The bank asks what to do with the schedule: keep the payment and shorten the term, or keep the term and reduce the payment.
The question sounds technical. The difference in cost is not.
Why they are not the same
Interest accrues on the outstanding balance for every month that balance exists. The overpayment reduces the balance identically in both cases — the difference is how long you keep paying.
Shortening the term leaves the payment unchanged, so the balance falls at the previous pace and the loan ends earlier. Fewer months with interest means less interest.
Lowering the payment spreads a smaller balance across the same number of years. You pay less each month, but for longer — and hand the lender more in total.
On a mortgage with a dozen or more years to run, the gap between the two can exceed the overpayment itself several times over.
When lowering the payment still makes sense
Arithmetic is not the only criterion. Reducing the payment makes sense when:
- the budget is tight and a lower payment genuinely reduces the risk of coming up short in a bad month — losing liquidity costs more than interest;
- an income change is coming — parental leave, going self-employed, a job change;
- you want to increase borrowing capacity before another obligation, because capacity is decided by the total of payments, not the total of balances.
Otherwise, shortening the term is cheaper.
When overpaying is not worth it at all
Before you overpay, check three things.
The rate on your other debts. Overpaying a mortgage while carrying a credit card balance is an expensive mistake — the card costs several times more.
Your emergency fund. Money put into a loan stops being available. Overpaying at the cost of the fund often ends with the first breakdown being covered by a more expensive loan.
Early repayment fees. Rules vary by country and product; read your own agreement rather than assuming.
How to work it out yourself
You need three numbers from the agreement: the outstanding balance, the interest rate and the number of payments left. With those you can compare both options and see the difference in total interest, instead of relying on a hunch.
It is worth doing this before talking to the lender. The overpayment form usually has one option pre-selected, and the default is not the one that is better for you.