Michelle is an award-winning chartered financial planner who holds the designation 'Fellow of the PFS' demonstrating her commitment to maintaining the highest standards of knowledge, ethical conduct, and professional practice. Michelle is also an accredited member of the Society of Later Life advisers. Michelle offers a fully personalised service tailored to each clients individual needs and goals, using an approach that was recognised and honoured by the Women in Financial Advice awards in 2021. Clients working with Michelle can expect a high level of professionalism, integrity and a lasting relationship built on trust and open communication
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.
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.
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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.
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.
You can accelerate your mortgage payments through regular or one-off lump sum payments to your lender. Some are really flexible and will allow you to set up a standing order to do this, if you plan to do it regularly. You can also pay over the phone.
You can also ask your mortgage lender to reduce your mortgage term, but that will mean that your monthly mortgage commitment is higher. It has the same effect overall.
You can increase your pension contributions through your employer. Some employers will offer salary sacrifice, and others will just set up another mechanism for your pension contributions to come out of your wages.
If you want to increase your contributions to a personal pension, you would make a standing order payment to a pension provider over the phone. You can also make one off lump sum payments to your personal pension. But you must be mindful of the annual pension allowance in all cases – and that’s why it’s really important to take advice.
It’s all about the interest savings. You’re not going to pay as much interest by making overpayments, and you’ll repay your mortgage earlier than you planned. You’re also going to build up equity faster, reducing the debt and giving you lower financial risk.
When you pay off the mortgage, it’s reducing your debt. That’s a guarantee. Your financial commitments are reducing, your mortgage payments are getting lower and you’re going to have the security of owning your own home outright earlier than you originally planned. Generally, it could give you a greater sense of financial wellbeing.
It’s such a personal decision. You’ve really got to think about your overall attitude to risk, your tax position and what’s really important to you. Your financial goals are the key, and it’s really important to get financial advice on that one.
Simply that you’ve got more retirement income. By increasing your pension contributions you’re saving more for your retirement over the long term. These contributions, together with investment performance, can provide a potentially higher retirement income when you decide that you don’t want to work as hard anymore.
Here in the UK we have an excellent tax relief regime for our pensions. You can get tax relief at your highest margin on private pension contributions worth up to 100% of your annual earnings. A basic rate taxpayer and non earners will always get 20% tax relief (subject to the annual allowance limit) If you’re a higher-rate taxpayer you can get up to 40% tax relief and if you’re an additional rate taxpayer you can get up to 45% tax relief. Just be aware that you must pay sufficient tax at the higher or additional rate to claim the full 40% or 45% tax relief.
In addition, when the funds are invested they will grow tax free. There is no tax within the pension fund itself. When you take your pension benefit later on in life, you’re also entitled to take 25% of the value of the fund as tax-free cash.
You may also have the opportunity to have additional employer contributions. So if you are increasing your pension contributions in your workplace scheme and the employer matches your contributions, for every £1 you contribute your employer pays another £1 in. You’re gaining free money, essentially, plus long-term growth potential.
Your pension contributions will be invested in various types of assets, like stocks, shares and bonds. By increasing your pension contributions you have the opportunity to benefit from long-term investment growth. Of course, I need to say here that investment values can go down as well as up.
A final point is on inheritance tax planning. Pension savings are generally not liable to inheritance tax, so your pension contributions could be an effective way to mitigate potential inheritance tax on your estate. Of course the tax treatment of pensions is subject to change and this is based on current legislation.
You’ve got the pension tax relief I just mentioned, so you’ve got income tax relief at your highest margin of tax. All personal pension contributions within your annual allowance receive 20% tax relief. If you are a higher rate taxpayer you can claim additional tax relief of 20% up to the amount of income you have paid 40% tax on and an additional 25% relief up to the amount of any income you have paid 45% tax on.
It’s also possible that your pension contributions could reduce your overall income, enabling you to claim certain state benefits. Once you go over a certain threshold of earnings you start to lose your personal allowance.
Making pension contributions can bring down your overall income and reinstate that personal allowance. These are some really specific examples that will affect individuals in different ways – so they are things that you should get financial advice about.
I wouldn’t call them risks, but I would definitely say there are factors to consider when making your decision. If you decide to overpay your mortgage, it could lead to insufficient retirement savings.
Solely focusing on your mortgage and not making pension contributions means you could miss out on higher employer contributions. There could be a missed tax advantage and potentially a mortgage penalty or restriction from your lender.
Relying heavily on home equity without considering your retirement savings could potentially leave you vulnerable in retirement, if you come across unexpected costs or you need to retire earlier. Plus, don’t forget the housing market can change. Property values can fall as well as rise.
In the current climate, we are in a rising interest rate market – but some people were able to secure a lower rate of interest prior to these rises [podcast recorded in July 2023]. If they are on a low, fixed rate they may consider making pension contributions – because their interest rate is much lower than they think they could achieve on their pension savings.
Conversely, if your mortgage interest rate is high, or you are worried about higher rates when it’s time to remortgage you may feel more comfortable in reducing your debt and the amount of interest you’re paying.
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It’s really down to the individual circumstances, but there are many benefits to overpaying your mortgage:
But of course, it all comes down to your overall financial position, your goals and priorities.
Again, it’s all down to personal circumstances and preferences. But if you’ve got a longer time until retirement it could be more beneficial to focus on your pension. Also, if it offers you a better tax position and there’s a tangible tax saving that would make your whole household income better, that could be worth considering.
If your employer offers matching pension contributions and it makes sense for you to do it, it could be a good opportunity. Plus, if your mortgage lender will impose a penalty or restriction to make overpayments, then it doesn’t make sense to do that. An alternative to paying into a pension that should be considered in this instance is making payments into a high-interest savings account or an investment so that the money can be retained and accessible, so that once the penalties on the mortgage have ended you can make a decision about whether to pay a lump sum off the balance.
THE VALUE OF PENSIONS & INVESTMENTS AND ANY INCOME FROM THEM CAN FALL AS WELL AS RISE. YOU MAY NOT GET BACK THE AMOUNT ORIGINALLY INVESTED.
TAX TREATMENT VARIES ACCORDING TO INDIVIDUAL CIRCUMSTANCES AND IS SUBJECT TO CHANGE.
ESTATE PLANNING IS NOT REGULATED BY THE FINANCIAL CONDUCT AUTHORITY.
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