Alice Guy crunches the numbers on mortgages and pensions and explains which is better to overpay first.
After a long period of ultra-low interest rates, many of us are facing a dilemma in 2023.
Interest rates are on the rise and thousands of us on fixed mortgage deals are frantically overpaying our mortgages before they’re due for renewal at a higher interest rate.
But we also know that, in the long run, many of us need to boost our pension contributions to help us achieve a big enough pot for a comfortable retirement. Leave those pension payments to the last minute and we’ve less time for investment compounding to boost our wealth.
So, with rising interest rates, which should we prioritise – pension or mortgage payments? Which will make us richer in the long run?
Paying off the mortgage
There’s something extremely satisfying about paying off our mortgage early. For many of us, it’s our largest and longest debt, as well as our biggest household bill.
Many of us also want to be mortgage free by the time we hit retirement age, if not before. Overpaying a 25-year £200,000 mortgage by £200 a month could mean you’re mortgage free six years earlier and, if interest rates average 5%, you could save a whopping £41,841 in interest.
Is it better then, to concentrate on paying off the mortgage first and then turn to overpaying our pension? How much difference does the order we do things change our long-term wealth?
It will be no surprise to long-term investors and mortgage holders to know that some of that depends on the exact level of investment growth and interest rates in the future.
Example 1: 5% interest rates and 5% investment growth
Sam has a 20-year mortgage of £200,000 – I’ve assumed 5% investment growth, 5% mortgage interest rates and 20% tax relief:
- Option 1 - Sam overpays his mortgage by £200 per month for the whole mortgage term and pays off his mortgage around four years early. He then invests his previous monthly mortgage payment of £1,520 per month (plus tax relief) into his pension for the next four years and ends up with £100,728 in additional pension investment.
- Option 2 – Sam contributes an additional £200 (plus tax relief) to his pension for 20 years and achieves extra pension wealth of £102,758 – almost exactly the same as option 1.
- Option 3 - Sam overpays his mortgage four years early but then can’t get tax relief on his future pension contributions, giving him £80,582 extra pension wealth, much lower than the other scenarios.
It turns out that when mortgage interest rates and investment growth are the same, it doesn’t make much difference whether homeowners prioritise pension or mortgage overpayments. Sam is very slightly better off with option 1, paying more into his pension up front.
In this example, the loss of pension tax relief, causes Sam’s extra investment wealth to drop by around 20%. There’s a limit to how much tax relief you can get in any given tax year, as you can only get relief on tax you’ve paid. This means trying to pay a lot into your pension quickly can mean you miss out.
Example 2: 4% interest rates and 6% investment growth
But what if investment growth outstrips interest rates in the future? Stock market growth has historically beaten interest rates over time.
Well, you’re probably not surprised that if we rerun the example above with interest rates of 4% and investment growth of 6%, Sam does a fair bit better paying into his pension first, leaving his investments longer to grow.
- Option 1 - Sam overpays his mortgage by £200 per month for the rest of the mortgage term and pays off his debt around four years early. He then invests his previous monthly mortgage payment of £1,412 per month (plus tax relief) into his pension for the next four years and ends up with £93,251 in additional pension investment.
- Option 2 – Sam instead contributes an additional £200 (plus tax relief) to his pension for 20 years and achieves extra pension wealth of £115,510 – around £22,000 higher than option 1.
- Option 3 – Sam overpays his mortgage four years early but then can’t get tax relief on his future pension contributions, leading to a reduced £74,601 extra pension wealth, quite a bit lower than the other scenarios.
Example 3: 6% interest rates and 4% investment growth
But what about if interest rates are higher than investment growth in the future? It seems unlikely in the long run, but it’s possible.
If we again rerun the same example with interest rates of 6% and investment growth of 4%, Sam would be slightly better off paying off his mortgage first.
- Option 1 – Sam overpays his mortgage by £200 per month, leaving him mortgage free around four years early. He then invests his previous monthly mortgage payment of £1,633 per month (plus tax relief) into his pension for the next four years, achieving £108,444 additional pension investment.
- Option 2 – Sam contributes an additional £200 (plus tax relief of £50) to his pension for 20 years, ending up with extra pension wealth of £91,693 – around £17,000 lower than option 1.
- Option 3 – Sam overpays his mortgage four years early but can’t get tax relief on their future pension contributions, leading to £86,765 extra pension wealth, lower than both other scenarios.
Extra pension wealth after 20 years
|5% interest rates, 5% investment growth||4% interest rates, 6% investment growth||6% interest rates, 4% investment growth|
|Option 1||Overpaying mortgage first and then pension (with tax relief)||£100,728||£93,251||£108,444|
|Option 2||Paying into pension first||£102,758||£115,510||£91,693|
|Option 3||Overpaying mortgage first and then pension (no tax relief)||£80,582||£74,601||£86,765|
|Option 4||Half and half (overpay mortgage and pension)||£101,992||£103,168||£101,979|
|Difference between options 1 & 2||-£2,030||-£22,259||£16,751|
|20-year repayment mortgage|
|Option 1,2 & 3 - overpayment into mortgage or pension of £200 per month|
|Option 1 & 3 - once mortgage is paid off, divert mortgage payment into pension|
|Option 4 - overpaying mortgage and pension by £100 per month, divert mortgage payment into pension once paid off|
The impact of interest rates and investment growth
So, mortgage interest rates and investment growth make a slight difference to our calculations, but not as much as we might think – the bigger the gap, the more the difference.
In general, if investment growth is higher than interest rates then we’ll be better off paying into our pension first, giving our investments longer to grow.
In contrast, if interest rates are higher than investment growth then we could be better off paying down our mortgage first. We’ll save more on interest than we gain in investment growth.
Other factors affecting our priorities
In reality, each of us is different, and there are many additional factors apart from interest rates and investment growth that affect our finances and whether we decide to prioritise mortgage or pension payments.
Here are some of those factors:
- Tax relief – tax relief on pension contributions makes a huge difference to our pension wealth and it’s usually a good idea to make the most of it. It’s possible that delaying pension contributions into the future will mean that the rules on tax relief change or you receive a lower level of relief. Maximising your pension tax relief is even more important for higher-rate taxpayers who receive higher levels of tax relief.
- Employers’ pension contributions – like pension tax relief, employers’ pension contributions can add significantly to our pension wealth. Again, it usually makes sense to make the most of those contributions and not reduce our pension contributions if this would mean losing employers’ contributions.
- Financial security – it can be a great relief to pay off your mortgage early, so you don’t have to worry if ill-health strikes, or you lose your job. It means you’ve got more flexibility to retire early, albeit on a possibly reduced income.
- Other financial circumstances – your other financial commitments and existing wealth might affect your decision. For example, if you have a generous defined benefit pension, you might not need additional pension income and prefer the security of knowing your mortgage is paid off.
- Your attitude to risk – your expectations about the level of mortgage interest rates and investment returns in the future might affect your decision.
- The return of ultra-low interest rates – if we see a return to ultra-low interest rates in the future, then this could make investing a lot more attractive than paying off our mortgage more quickly.
As for me, with 20 years till retirement and a big mortgage still outstanding, I’m slightly overpaying our mortgage but also keeping up regular investing into my pension.
In the absence of a crystal ball to predict interest rates and investment growth, I’m sitting on the fence and trying to do a little bit of everything.
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