Should I Overpay My Mortgage or Pay into a Pension?

What is the difference between overpaying a mortgage and paying into a pension? 

Your mortgage debt is charged interest, usually on a daily basis, so by making overpayments on your mortgage you will reduce the amount you owe. The interest being charged will therefore be lower than if you didn’t make the overpayment. 

Pension contributions in a money purchase arrangement are added to an investment pool that will rise and fall in line with investment returns. In addition, any pension contributions you make will usually be entitled to tax relief, reducing the amount of tax you pay. 

The main difference is that making mortgage overpayments guarantees that you’re going to reduce debt, while making pension contributions has greater potential returns. 

Should I overpay my mortgage or increase my pension savings?

This is a really personal decision, and it’s likely to be based on a number of different factors. Generally speaking, it’s advisable to pay down debt before you consider investing. But you may want to take interest rates into consideration. You could have a really low interest rate on your mortgage and think you could achieve a higher rate of growth through your pension investment performance. 

As pensions are invested you should plan to leave your money invested for at least 5 years to allow for some short-term dips in value.  In addition, it’s important to note that pensions are not accessible until age 55 (rising to 57). We don’t know what will happen to interest rates in the future so a possible alternative to overpaying your mortgage whilst rates are low is to pay money into a high-interest savings account or investment so that you can have access to your money.

Conversely, you might have a really high mortgage interest rate, and therefore want to pay down that debt to reduce the interest. Other things to consider is the term – how long you’ve got left on your mortgage, and how long until retirement. 

If you’re quite close to retirement, you might be better off paying down the mortgage debt to reduce your outgoings. If you’re further away from retiring, increasing your pension contributions could give you a greater source of wealth as an income in retirement.  

Other relevant things include how your mortgage is set up. Some lenders impose a restriction on your ability to overpay. Risk tolerance is important too – are you able to take risks or do you not like risk? Mortgage overpayments are guaranteed to reduce your debt, whereas your pension contributions are exposed to investment risk and rises and falls. They’re never guaranteed to offer you a return.

Your tax position could influence your decision as well. It could be more advantageous to make pension contributions and reduce your overall tax. There’s a couple of scenarios I can think of – for example, if you’re a parent and you’re entitled to Child Benefit, but you get a pay rise that pushes your salary over the earnings threshold. In that case, you could be better off making a pension contribution to maintain your entitlement to child benefit.

The last thing to consider is your overall financial goals – are you more focused on being debt-free and owning your home outright, or something else? I would definitely recommend that you get financial advice before you make your decision.

Why should I balance a pension with my mortgage?

It’s really important to balance your retirement savings and your mortgage, because when you don’t want to work as much in the future you will have to meet your household expenditure with another source of income. 

Pension contributions are a really tax efficient way of saving for that period in your life. The more you contribute, the more you’re going to have available to you. The longer you contribute over will also increase how much you have in retirement. 

On the flip side, a mortgage enables you to purchase a property when you can’t afford to buy one outright, and owning your home reduces your costs in retirement. You won’t have any rent or mortgage costs if you are mortgage-free, so you won’t need as much income. So the two are almost the same goal, if you like. But one way may be more right for you than another.

How does overpaying a mortgage affect the total amount paid? Will I be charged for overpaying on my mortgage?

Overpaying your mortgage reduces the total amount you have to pay back. When you make your overpayment, the extra amount reduces the debt you owe to your mortgage lender – also known as the capital amount. 

By reducing that debt, you’re decreasing the sum on which interest is calculated. If you keep your mortgage payments the same and make overpayments, the amount of interest you pay, compared to the amount originally due to be paid, will also be lower. So your standard mortgage payment becomes a capital overpayment too. 

This has the effect of shortening how long it will take you to repay your overall mortgage, and reducing the total amount you end up paying for your mortgage in the end. 

It is really important to know that some lenders may impose penalties or restrictions on your ability to overpay the mortgage. The first thing you need to do before making overpayments is to check your mortgage terms or call your mortgage lender.