Deciding whether to overpay the mortgage or pay more into the pension is a tough decision. The choice of paying less interest and eventually having a paid-for home against potentially much higher returns that aren’t guaranteed.
Disclaimer: This is not financial advice. This is post is for educational purposes only. If you are unsure of what to do consider seeking an independent financial advisor.
Every couple of years I review my own personal finances and decide whether I should overpay the mortgage or invest more in my pension. The factors which govern the decision change can every year.
By overpaying the mortgage you can typically expect lower returns but with a higher level of security due to reducing your levels of debt. Paying more into a pension will benefit you in the form of tax relief as well as higher expected returns although these returns are not guaranteed and your capital is at risk depending on how it is invested.
Whether you decide to overpay your mortgage or pay more into your pension will depend on a number of factors unique to your personal situation and psychology.
Here are some of the things to consider.
Security of Owning More of Your Home
One of the biggest factors in deciding whether to overpay your mortgage or pay more into your pension is based on your own psychology and risk levels towards money, rather than black and white mathematical scenarios.
Debt is a risk. If at any point in the future you can’t afford to keep up with your mortgage payments you risk losing your home. It is, therefore, no surprise that many people take great comfort from paying off their mortgage and owning their home outright.
Once paid off you have the option of putting the equivalent of repayments into your pension or other investments. How those investments fluctuate feels less relevant when you have your home paid off.
These are some of the key questions you might ask yourself:
- Do you want to feel more secure in having paid off more of your home? That feeling of security brings happiness to some.
- How comfortable are you with the size of your current mortgage payments? Do you feel overextended and want to build up more equity?
- In recent times we have lived during a period of very low-interest rates, but if that should change will you be able to afford higher repayments if interest rates rise?
- Do you have enough savings elsewhere to cover payments should your income reduce and affording the mortgage ever become a temporary issue. Do you have an emergency fund to cover a possible job loss?
- Do you want to clear your mortgage before you retire so your pension doesn’t have to be large enough to cover your monthly mortgage payments? Are you on track to do this?
Comparing Interest Rates and Investment Returns
In this era of exceeding low interest rates the financial long term benefits of overpaying the mortgage in terms of returns are very low.
Typically over the long term, we can expect returns from pension investments to be an average of 7 to 8%, which compounding over many years can result in significantly higher returns than saving on 1.5-2% mortgage interest.
The lower interest rates are, the more compelling it is to invest in a pension.
However, investment returns are not guaranteed and your capital is at risk.
Workout How Much Will You Save Overpaying Mortgage
To start with you can use the MSE overpayment calculator to work out how much money you will save if you start overpaying your mortgage, either with a lump sum or recurring payments.
- A £1000 lump sum payment on a £100,000 mortgage at an interest rate of 2% would save £642 over 25 years.
- A £1000 lump sum payment on a £100,000 mortgage at an interest rate of 4% would save £1684 over 25 years.
At the time of writing, it’s quite possible to get a mortgage rate at 2% or lower.
Workout Potential Investment Returns
Next, you can work out your potential investment returns
Using a compound interest calculator to calculate the following rates of return annually:
£1000 at 2% returns over 25 years would be worth £1640.41 (£1000 principal + £640.41 interest)
£1000 at 7% returns over 25 years would be worth £5427.42 (£1000 principal + £4427.42 interest)
A difference of 5% in the rates of returns results in nearly 7 times more interest, and more than quadrupling the intial starting principal sum of £1000.
I prefer to err on the side of caution using 7%, but if 8% returns can be achieved over 25 years, the interest alone is £6340, almost 10 times that of overpaying a mortgage 2%.
These calculations don’t include the fact you would benefit from the 25% tax top up and in effect start with £1000 + £250 added on top. Higher tax rate taxpayers claim the extra 25% to 31% through their self-assessment tax returns. Although not added directly to the pension pot it effectively means the initial £1000 has cost you less.
This extra boost makes an even bigger difference to projected returns.
Over Paying the Mortgage
The other key factors to consider when deciding whether to over mortgage or invest in a pension are:
If you are considering overpaying your mortgage, make sure there are no redemption fees to pay, which in some cases could amount to thousands of pounds. These are typically on fixed-rate term mortgages. Although some of these still let you overpay to a certain amount without incurring fees, for example, overpay up to 10% with no fees. Check your mortgage T&C’s.
If you are on a fixed-term mortgage your only option in the meantime might be to pay extra into your pension until a time when you can actually over your mortgage.
If inflation is above the interest rate of your mortgage you are essentially losing value on those returns. One of the advantages of investing in your pension is that you can expect the returns to exceed inflation, even if not guaranteed.
Another factor that some people take into consideration is how inflation reduces the value of debt over time. Your £150,000 mortgage may not seem like such a huge debt in 25 years time when a new mortgage on the same property might be £500,000 due to inflation.
By paying off the mortgage debt early you are potentially losing out on the benefit of inflation on the debt.
If you put your money in a pension it’s out of reach until you either qualify for the 25% tax-free lump sum or you reach retirement age.
However, with equity in a house in theory it is accessible, (albeit not readily) should you want or need to.
For example, some people remortgage if an opportunity for higher returns arises, such as buying an investment buy to let. Or perhaps they want to build an extension that will also increase the value of their property.
Other people might suffer from ill health, be unable to work and want to take advantage of equity release years before they are due to retire. (I’ve seen people benefit from this first hand).
Another example might be when people downsize property when the kids have all left home and free up some equity to enjoy life while they can.
Although these aren’t generally the options considered by most people when aiming to pay off their home, but they are factors for some, often based on unexpected life circumstances.
Advantages of Overpaying Mortgage:
- Guaranteed returns
- No tax on the savings you make
- Feeling of security
- Higher % equity in the property (lower Loan to Value) could qualify you for better rate deals in future
- Potentially the option for lower payments if you remortgage over the same term
- A paid-off mortgage significantly reduces monthly outgoings
- Lower pension required if your is home paid off
- Building equity you could in theory access before retirement (remortgage, sell to rent, equity release)
Disadvantages of Overpaying Mortgage:
- Your overpayments are not accessible in times of need (you may be able to withdraw equity but not when you can’t afford the repayments
- Your home is still potentially at risk if ever you can’t afford to meet repayments in the future
- Not allowing inflation to reduce the relative value of the debt over time
Paying More Into Your Pension
The higher the rate of tax you pay, the more advantageous paying into a pension becomes. 40% tax relief is more than the rate of tax you will pay on earnings in retirement if you are a basic ratepayer and in a good position to be in.
Pension Tax Relief (Extra 20-45%)
One of the key factors in favour of paying into a pension is the tax relief you benefit from immediately.
The amount of tax relief you get is based on your income in the current financial year.
- Non-taxpayers will get 20%
- Basic rate taxpayers will get 20%
- High rate taxpayers can get 40%%
- Additional rate taxpayers get 45%.
This means as a basic rate taxpayer if you contribute £80 to your pension the government will add £20 making a total of £100.
With higher rate taxpayers, if they also contribute £80 to their pension the government adds £20. The remaining £20 is claimed as tax relief through your Self Assessment tax return or contact HMRC. See the HMRC tax relief page.
This is a key factor, as you can see it is far more beneficial for higher and additional rate taxpayers to pay into a pension.
Bear in mind, you will get taxed on pension income when you come to draw it (excluding the 25% tax-free lump sum).
If you are someone benefiting from higher rates of tax relief and expecting to be a basic rate taxpayer in retirement the benefit is at its greatest.
For more information on pension tax relief and a pension tax relief, calculator by Which? click here.
Workplace Pensions – Matched Contributions Boost
If you have a workplace pension and get matched contributions increased from your employer this is the best position to be in and well worth considering.
Matched contributions and tax relief combined is the heaviest weighting towards it being most beneficial to pay more into your pension. It’s essentially two lots of additional free money.
However, not everyone has a workplace pension if they are self employed.
Advantages of Paying More Into Pension
- Pension tax relief (20-45%)
- Workplace pension – matched contributions
- Higher potential returns
- Could potential pay off the mortgage in the future with the 25% tax-free lump sum
Disadvantages of Paying More Into Pension
- No access to money
- Pension rules can change (age of drawing, taxation)
- Returns not guaranteed (higher risk)
- Drawings are taxed
Other Factors to Consider
Current Mortgage and Pension Pot Size
Another factor to maybe consider is the overall size of your mortgage and your pension pot.
If you have a comfortable mortgage but haven’t even started a pension, now could be the time to start.
Or vice versa, perhaps you have built a pension pot over years but have recently taken out a much bigger mortgage.
Age / Timeframe
It could be argued that the younger you are and the longer timeline of your pension the more advantageous it might be to invest in your pension so the magic of compounding those returns can start to work as soon as possible.
With a shorter timeline, say 5-10 years, there’s less time for your investments to grow.
Your Overall Personal Finances
Are your personal finances in good enough order to be
Have you paid off other interesting bearing debts?
Do you have a 3 – 6 month emergency fund, to cover any unexpected expenses or life situations such as losing a job and covering those mortgage payments in times of need?
These are 2 key questions that should be considered before even deciding to pay more into a pension or overpay the mortgage.
Another factor might be whether you have other savings or accessible investments with which to cover mortgage costs if you ever faced a loss of income. If you know you can cover the mortgage in any event, this may make it easier for some to opt towards paying more in the pension.
Another option you have is to do some of both, overpay the mortgage and increase pension contributions, just doing less of each.
You can review your payments annually and adjust anytime one way or the other based on the relevant changes to the financial metrics and your own personal financial situation.
If you are unsure, often a balanced approach is a good way to go.
What Do I do?
Over the years I have opted to do both, overpay the mortgage and pay extra into my pension. Some years more of one than the other, and in other years just choosing one of the options.
Let’s assume going forward, my personal circumstances and the financial metrics change, here’s what I would consider doing:
- Higher rate taxpayer with matched workplace pension contributions – I’d pay into a pension
- Just a higher rate taxpayer but no workplace pension, I’d still lean heavily towards paying into a pension
- If I was a basic rate taxpayer I would more inclined to either focus on reducing mortgage or split between both
- If interest rates rose to 3 to 4% Id consider paying off more of the mortgage (or doing both).
- If I moved house and took on a much larger mortgage that I wasn’t comfortable with long term I’d overpay the mortgage
- If stock markets took a huge dip I’d temporarily pay more into my pension
In reality, none of the above factors are black and white as there are always other factors to consider.
The financial metrics are constantly changing and will continue to do so over the course of a mortgage term.
At times I have fluctuated between times of wanting to clear my mortgage or not.
However, I didn’t expect to get an interest rate of 1.74%, which for me skews me towards paying into my pension.
Ultimately we are all in different financial situations as well as having our own personal views on debt and risk. As long as we are giving due thought to all the factors it should enable us to choose options that we feel most comfortable with.
Unless a one-off lump sum decision, the allocation of funds to overpaying a mortgage or paid into a pension can be changed at any time.
Your Say – What Would You Do?
Has this post helped you come to a decision?
What is your preferred option and why?
Feel free to share in the comments.