Overpaying a mortgage or topping up a pension: how to maximise wealth

• Both options of overpaying your mortgage or topping up your pension could have a huge impact on your wealth 
• ii crunch the numbers on the savings you could make 

With the conversation around mortgages shifting following the cut to interest rates, interactive investor(ii) provides updated research on whether overpaying your mortgage or topping up your pension contributions could have the biggest impact on maximising your wealth. 

The results revealed that overpaying your mortgage or pension could both help to maximise your wealth over time under different circumstances, and maximising your pension tax relief can play a huge role in this. 

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The calculations are for illustrative purposes only, and compare someone with a £200,000 mortgage with a term of 25 years, who paid £200 extra into both their pension and mortgage for 25 years (which would grow to £250 after tax relief), versus someone who overpays their mortgage by £200 each month until the mortgage is paid off early, and then redirects their previous mortgage payment plus £200 over-payments into their pension until they reached 25 years.

For this example, we’ve assumed interest rates remain static, although in reality, they change over time. 

Table below shows the amount expected in your pension after overpaying your mortgage first and then topping up your pension (with and without tax relief), versus if you topped up your pension first

Craig Rickman, Personal Finance and Pensions Expert, interactive investor, says: “The recent falls in mortgage rates may shift the dynamics of the overpaying mortgage vs topping up pensions debate. 

“There is, of course, obvious appeal to reducing your mortgage. Becoming debt-free is a core milestone for many of us and often represent a giant leap towards the holy grail of financial freedom. You’ll also save on interest payments over the life of the loan, which could amount to thousands of pounds. You do, however, need to be wary of any early repayment charges imposed by your lender.

“The arguments for using spare cash to boost your pension are equally strong – and in many cases even stronger.

“Not only is there the prospect of healthy investment returns over the long term, but pensions also come with attractive upfront tax advantages.

“Basic rate and non-taxpayers can get 20% relief which comes in the form of a government top-up, meaning an £80 contribution is boosted to £100. If you pay higher rates of income tax, the benefits are even more pronounced. A £100 pension payment effectively costs £60 and £55 for higher-rate and additional-rate taxpayers, respectively, giving your savings an immediate and sizeable shot in the arm. What’s more, any investments inside a pension grow free from tax too.

“There’s no one-size-fits-all answer here - both options can improve your long-term financial security. The right path for you will depend on your individual circumstances, including your financial goals, current mortgage terms, tax position, and risk tolerance. 

“For those torn between the two, the good news is the decision isn’t binary. You can choose to split any surplus savings or income between reducing your mortgage and boosting your pension.”

Scenario 1: interest rate 5%, investment growth 3% 

Overpaying a 25-year £200,000 mortgage with an average interest rate of 5% by £200 a month means that you would pay off your mortgage around six years early. Following this, if you then invested the previous monthly mortgage payment of £1,169 per month plus £200 overpayment (£1,369 plus 20% tax relief) into a pension for the next six years, this could amount to a total of £138,716 in additional pension investment, assuming 3% investment growth. 

If you instead choose to invest the extra £200 a month, plus tax relief, in a pension over the same time period, this could result in extra pension wealth of £110,881 – assuming an investment return of 3% per year. This is almost £28,000 less than the previous scenario.

Scenario 2: interest rate 4%, investment growth 4% 

If we rerun the above example, with interest rates of 4% and investment growth of 4%, overpaying your mortgage or pension is roughly equal from a returns perspective 

In this scenario, if you overpay your mortgage by £200 a month (again resulting in the debt being paid off six years early), and then invest the previous mortgage payment of £1,056 per month plus £200 overpayment (£1,256 plus tax relief) into a pension for the next six years, you may end up with £127,256 additional pension investment. 

If instead you put the additional £200 (plus tax relief) in the pension for 25 years, this would result in extra pension wealth of £127,228 – which is only £28 more than the first option.

However, you should be cautious, as losing out on pension tax relief in the future could significantly affect your overall wealth. As overpaying a 25-year £200,000 mortgage with an average interest rate of 4% would result in the debt being paid off six years early, investing the previous monthly mortgage payment of £1,056 per month plus £200 overpayment (£1,256 without 20% tax relief) into a pension for the following six years would result in £101,805 in additional pension investment – much lower than the previous two options.  

Scenario 3: interest rate 5%, investment growth 7%

If we rerun the same example with interest rates of 5% and investment growth of 7%, it is much more lucrative to top up your pension. 

In this scenario, overpaying the mortgage by £200 per month (again, resulting in the debt being paid off around six years early), and then investing the previous mortgage payment of £1,169 per month plus £200 overpayment and tax relief for the following six years could result in £156,675 additional pension investment.

However, if you instead put the additional £200 (plus tax relief) into your pension for 25 years, you could end up with extra pension wealth of £195,834 – over £39,000 more than the previous option. 

Craig Rickman added: “As you may expect, the gap between interest rates and expected investment growth result in different outcomes. 

“Put simply, if the interest rate is higher than the anticipated investment growth, overpaying your mortgage first and then adding to your pension is the preferable option – in money terms, anyway. 

“On the flip side, if investment growth outstrips the interest rate you pay, topping up your pension might be savvier. 

“When the interest rate and expected investment growth are the same, it results in very similar outcomes.

“When choosing between the two options, the rate of tax you pay is a crucial factor. Those in the higher-rate and additional-rate tax bands can gain 40% or 45% upfront relief, respectively, on pension payments. 

“A further consideration is whether you’re caught in one of the 60% tax traps. Paying into a pension can not only trim your tax bill but may also help you to swerve or reduce the High-Income Child Benefit charge or keep your personal income tax allowance. It’s vital to factor this into any decision you ultimately make.”