Overpaying the mortgage or topping up your pension: which will make you richer?

With interest rates rising at the fastest rate in recent history, interactive investor provides updated research on whether prioritising overpaying your mortgage or upping pension contributions could make you richer in the long run.

The results show that overpaying mortgages or pension could both make you richer under different circumstances and that maximising your pension tax relief could make a big difference to your wealth over time.

• Invest with ii: Open a SIPP | What is a SIPP | SIPP Cashback Offers

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 their pension for 25 years (which would grow to £250 after tax relief), to someone who paid £200 extra off their mortgage, clearing their mortgage early. They then diverted the mortgage payments plus the extra £200 into their pension until they reached 25 years in total. For this illustration we’ve assumed interest rates remain static, although in reality they change over time.

Assumptions: 25-year repayment mortgage, 20% tax relief, 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, returns net of investment fees.

Alice Guy, Head of Pensions and Savings, interactive investor says: “For most people, it’s not a good idea to stop paying into your pension to top up your mortgage, because you’ll potentially lose free employer contributions, which can hugely boost your pension wealth in the long run. If however, you have extra cash spare to invest, you’ll have a difficult decision to make: whether to use the extra cash to pay off your mortgage more quickly or boost your pension savings instead. Ideally, if you can afford it, it’s best to do both.

“Without a crystal ball it’s difficult to say which is a better option as the outcome largely depends on the level of interest rates and stock market performance. Broadly speaking, if the stock market grows more than mortgage interest rates then you could be better off concentrating on boosting your pension saving, whereas if mortgage interest rates outstrip investment performance, you might benefit more from paying off your mortgage first and then concentrating on boosting your pension. If mortgage rates and investment performance are the same, then there’s not much in it.

“Of course, in reality interest rates don’t remain static, and you may therefore decide to prioritise overpaying your mortgage or pension at different times.

“It’s also worth pointing out that pension tax relief could make a big difference to your decision. There’s a risk that someone who pays off their mortgage first and then maxes out their pension contributions could miss out on valuable tax relief if their pension contributions outstrip their taxable earnings. If you’re a higher-rate taxpayer, it’s also possible that you won’t get as much tax relief if you decide to wait to boost your pension wealth. It’s possible that you’ll not earn enough in the future to get higher-rate tax relief if you pile a large amount into your pension in just a few years.

• Should you cash in investments to pay off your mortgage?
• UK household costs rocket to highest in 30 years
• Interest rates rise to 5.25%: what does this mean for me?

“When it comes to money, it’s not always a simple calculation as psychology and financial priorities also come into play. For some of us, financial security is a huge priority and clearing the mortgage early can give us peace of mind in case we lose our job or our circumstances change.

“There’s also something to be said for keeping plugging away at investing and pension saving over the years. There’s always a danger that we can put off investing until the future, leaving us less time for investment compounding to work its magic. Life also has a habit of getting in the way of our best-laid plans, so it can be risky to put off pension saving for the future.”

Scenario 1 : interest rates 6%, investment growth 5%

Overpaying a 25-year £200,000 mortgage with an average interest rate of 6% by £200 a month means paying off your mortgage six years early. Investing the previous monthly mortgage payment of £1,288 per month (plus 20% tax relief) into a pension for the next six years amounts to £165,901 in additional pension investment, assuming 5% investment growth.

Assuming an investment return of 5% per year, choosing to invest the extra £200 a month, plus the tax relief, in a pension over the same period would result in extra pension wealth of £148,877- £17,000 less than the previous scenario.

Be careful because losing out on pension tax relief in the future could significantly affect your total wealth. Overpaying a 25-year £200,000 mortgage with an average interest rate of 6% by £200 a month means the debt will be paid off six years early. Investing the previous monthly mortgage payment of £1,288 per month (without 20% tax relief) into a pension for the next six years would amount to £132,720 in additional pension investment, much lower than the other two options.

Scenario 2 : interest rates 5%, investment growth 6%

If we rerun the example above with interest rates of 5% and investment growth of 6%, paying into the pension first, leaving the investments longer to grow, wins out in terms of returns.

In this scenario, overpaying the mortgage by £200 per month for the rest of the mortgage term still means the debt will be paid off six years early. Investing the previous monthly mortgage payment of £1,169 per month (plus tax relief) into a pension for the next six years amounts to £152,758 in additional pension investment.

But putting the additional £200 (plus tax relief) into a pension for 25 years would result in extra pension wealth of £173,248 – around £20,000 higher than the previous scenario.

Scenario 3: 6% interest rates and 6% investment growth

If we rerun the same example with interest rates of 6% and investment growth of 6%, overpaying your mortgage or pension is roughly equal from a returns perspective.

In this scenario, overpaying the mortgage by £200 a month (again, resulting in the debt being paid off six years early) and then investing the previous mortgage payment of £1,288 per month (plus tax relief) into a pension for the next six years could result in £171,455 additional pension investment.

If instead, you put the additional £200 (plus tax relief) into the pension for 20 years, you could end up with extra pension wealth of £173,248 – around £2,000 higher than option 1.