Each month we put one of your questions to our experts. This month’s question is answered by Bertrand Pole, a technical specialist based in our Haywards Heath office and Sally Beresford, a financial planning partner based in Manchester.
Q. I’m 32 years old and I’ve recently had a pay rise and want to either make overpayments to my mortgage or additional contributions to my pension. The term left on my mortgage is another 35 years. Which would be the more beneficial option?
Bertrand Pole, Technical Specialist
Deciding whether to pay off more of your mortgage or save more into a pension is a difficult one to answer as both options are good financial practices. A lot of people don’t do either and end up spending more on their lifestyle such as more holidays, nights out or luxuries. However, there are pros and cons to each and you need to take other factors into consideration when deciding which option is best for you.
Pensions come with tax benefits
From a purely financial point of view, under current economic circumstances, paying more into your pension is still likely to give you a better financial outcome, especially if the pay rise takes you into a higher-rate tax band. When contributing into a pension you receive a tax rebate at your highest marginal rate, which would be lost if you simply paid off more of your debt. Many employers will match additional contributions up to a certain level, which you would not receive otherwise. Furthermore, the funds within your pension can achieve higher rates of return if invested wisely in the financial markets (although your investments can also go down in value as well). However, as interest rates are steadily rising for the first time in a decade, paying off your mortgage debt sooner could help reduce your outgoings and reduce the chances of a mortgage rate hike. Therefore, a more balanced approach should be taken depending on your personal circumstances.
Please note that the level of tax relief depends on individual circumstances and is subject to change.
Reducing mortgage debt creates options
Reducing your mortgage debt has other advantages than only saving mortgage interest. Firstly, when re-mortgaging, the lower the level of your loan compared to the value of your home means you will have more favourable deals available to you. This also has the added advantage that you will create more options to move home in the future, should you decide to purchase a bigger home - particularly if you start a family - want more space or simply want to move to a more desirable part of the country, which generally means higher property prices.
Consider your psychological profile
The other issue to take into account is your psychological profile; for some people, being burdened with debt causes them financial anxiety, especially in times of uncertainty, like what we are experiencing now. Therefore, reducing debt faster reduces that state and improves general feelings of happiness and mental wellbeing. However, it is important to understand that this could be at the cost of building up a sufficient pension pot to support you in later life. Getting onto the property ladder in the first place means you have already achieved an important financial goal and you have now replaced rental expense with a mortgage. Ensuring you are saving sufficiently into your pension to be able to enjoy a decent retirement in later life is an important next goal.
So in summary, it is important to have a good balance between paying off your mortgage and saving into your pension taking into account your personal circumstances. Paying funds into a pension has better tax advantages but locks your money away for a long period of time as you cannot access it until age 55 (increasing to age 57 from April 2028), while paying off debt can give you more flexibility in the medium term and help reduce your outgoings. A good way to gauge this is to speak to a financial adviser who can run various scenarios through a cashflow model to determine the best outcome for you.
Sally Beresford, Financial Planning Partner
I would suggest reviewing your mortgage to make sure you are on the best deal and interest rate possible, seeking advice from specialist mortgage brokers rather than just assuming your current lender will give you the best deal. Interest rates rose in 2022, and if your fixed-rate deal has ended, you will be paying the lender’s standard variable rate which will be much higher than what you have previously been paying (possibly around 4% AER), compared to a fixed-rate deal which may have been anything around 1% or 2% AER depending on your loan-to-value and fixed-rate period.
It is usually better to fix the rate of interest you pay on your mortgage for a certain period of time, such as two or five years. Not only will the interest be lower than on the lenders standard variable rate, but it will give you the comfort of being able to budget properly. You might find that you can reduce your monthly payments or the term of your mortgage by doing this alone – but do watch out for early repayment charges from your mortgage provider. In your circumstances it would probably be best to ensure that your mortgage is on a repayment basis whereby you are paying both capital and interest off your mortgage so the balance is cleared in full before the end of the term.
Investing for the long term
At 32, you have 36 years until your State pension age of 68. Rates of return on investing for the longer term in a diversified portfolio are typically higher than that of interest rates (although this could, of course, change), and with 36 years until retirement (unless you plan and invest well to retire early) you have a long-term investment ahead of you and can afford to take a reasonable degree of investment risk, seeking returns well in excess of interest rates.
When contributing to a pension you make a net contribution and you receive basic rate tax relief (20%) applied by your pension provider, and if you are a higher-rate taxpayer you can reclaim the further tax relief (20%) via your self-assessment tax return. So, for example, if you earn £30,000 a year and make a net contribution of £100 per month, after tax relief at basic rate is applied, you receive £125 in your pension.*
The benefits of employer pension schemes
You should check the terms of your employer’s pension scheme as you may find that they will offer to match your own contributions to a certain amount, for example, they may say if you pay 6% they will also pay 6%, so you get the benefit from your employer’s higher rate of contribution in addition to the tax relief benefit. Also, ask your employer if you can make contributions to the pension arrangement via salary sacrifice, which is you sacrificing a certain amount of salary in return for a gross employer pension contribution. Both you and your employer save National Insurance contributions as well as you paying less income tax. While it comes with some considerations and restrictions, salary sacrifice is a tax-efficient way to pay pension contributions, and saving tax and National Insurance means you benefit.
There are lots of online calculators you can use to work out what pension fund value you might need in retirement to give you the income you need. Contributing now to a pension, to benefit from longer-term growth, and taking advantage of mortgage interest rates while they are low should give you a good balance between the two. When you have pulled your figures together, and reviewed your mortgage, you may find that you can use your increase in pay to benefit both your pension and your mortgage repayments. Remember, you can allocate less to your pension as you have the addition of tax relief.
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*Examples of how tax or tax relief may apply are based on our understanding of current tax legislation. Whether any tax will be payable, at what level it is charged and whether you qualify for tax relief will depend upon individual circumstances and may be subject to change in the future.
This article does not constitute personal advice. If you are in doubt as to the suitability of an investment please contact one of our advisers.
This is based on our opinions which may change.
This article was previously published on Tilney prior to the launch of Evelyn Partners.