Overpay mortgage vs pay into pension

A number of clients ask me the question: “Shall I invest my surplus monthly income into a pension or overpay the mortgage?” The answer, assuming other high interest debts are repaid and a sufficient emergency fund is in place is, “It depends”. The first, and most important question I usually ask them is unrelated to any financial analysis.

“What does paying the mortgage off mean to you?”

To some it is a life goal, to others it helps them sleep better at night knowing that their biggest debt has been cleared. Has anyone ever felt bad paying off their mortgage?

Following on from this, we may then discuss a number of the topics below, taking into account their individual circumstances.

  • Highest tax rate now and in retirement: If the client is a higher or additional rate taxpayer now, and has accrued a minimal pension meaning they will likely be paying basic rate tax in retirement, putting the excess money into a pension (with corresponding tax relief meaning that a higher rate taxpayer needs to contribute £60 and an additional rate taxpayer only £55 to make a gross £100 contribution) rather than repaying the mortgage may make more sense than for a basic rate taxpayer who will also be paying basic rate tax on their pension in retirement.
  • Current mortgage Loan To Value (LTV): Would overpaying the mortgage give them access to a better rate?
  • How much headroom do they have in their monthly budget?: How well could they cope if base rates spiked? Would overpaying their mortgage give them a much needed buffer?
  • Stage of life: Investing in assets such as equities is for the long term. What is their target retirement date when they wish to start drawing their pension? Does this give sufficient time for any investment to grow?
  • Risk appetite: A client with a greater risk appetite will (assuming he has taken suitable advice) be likely to have a portfolio that will give him an expectation (but not guarantee) of greater returns (given suitable investment timescales) than someone with a lesser appetite. This may make the case for additional pension contributions over mortgage overpayment clearer cut given the greater difference between the expected investment returns and cost of mortgage borrowing.
  • Current mortgage rate and length of fix: It’s likely to make more sense for someone on a 2% fix for 5 years to contribute their surplus income to a pension than someone on a 2 year fix at 4%, all else being equal.
  • How much overpayment (without penalty) does the mortgage company allow?
  • Making additional contributions to the mortgage may mean a reduction in the term of any mortgage life insurance cover as the mortgage will be paid off sooner. This may give a cost saving.

This article is purely for information purposes and does not constitute individual advice. For advice on what is suitable please contact a financial adviser who will be able to provide advice based on your individual needs and circumstances.