I am 40 and have saved £200,000 into my work pension and £100,000 into my stocks and shares Isa.
My £300,000 mortgage is still fixed at 2 per cent for the next two years and the loan term runs until 2034.
I’d like to get mortgage-free before then and could put £300 a month towards that. Should I overpay the mortgage, or invest the money in my Isa?
Or should I consider topping up my pension and not worrying about the mortgage?
Building wealth: Would investing more in a pension or paying off a mortgage deliver better returns over the long term?
Rob Morgan, chief analyst at Charles Stanley Direct, replies: This is a very common dilemma. Paying down debt is a good thing, and long-term investing to benefit from the compounding of investment returns is also beneficial.
There are a few variables at play to decide which is best for you, but ultimately it may come down to how you feel and your general attitude to risk as much as the ‘spreadsheet’ answer.
There’s no doubt it’s necessary to keep debt under control and affordable. With an excellent 2 per cent mortgage deal for the next couple of years you are probably set fair for the time being.
However, the picture may change when you come to remortgage. It’s hard to predict where interest rates will be in two years, but you should generally assume that you’ll be rolling onto a less favourable deal at this point, and your mortgage costs will ramp up.
You’ll therefore potentially save thousands of pounds in interest by paying down your debt at a faster rate.
Mortgage payments are made up of two components; interest on the loan and a ‘principal’ amount, which goes towards paying down the outstanding balance.
The longer you have the mortgage and the higher the interest rate, the more you pay in interest. This is especially true in the early years when the loan balance is larger, and you are proportionally paying a lot more on the interest than the capital.
Yet overpaying your mortgage i.e. paying more than you need to under the terms of the loan agreement, comes with an ‘opportunity cost’.
In other words, had you invested the money could you have achieved a return more than the interest on the debt?
Allocating capital to well-managed and growing companies has, historically at least, been a reliable way to grow wealth.
However, to fully harness the power of the stock market and enjoy the benefit of compounded returns, you need to leave your money invested for a long time. An absolute minimum of five years but ideally decades. And you’ll want to make sure your money is invested as tax-efficiently as possible.
At higher mortgage interest rates there is arguably less of an opportunity cost. It is one thing bettering a 2 per cent or 3 per cent rate with investment returns, but achieving upwards of 6 per cent consistently is much more difficult.
The higher the interest rate the more it makes sense to take a safety-first approach and repay mortgage debt as quickly as possible – although there are other factors to consider such as any fees or early repayment charges associated with the terms of the loan.
Rob Morgan, chief analyst at Charles Stanley Direct: With a low mortgage rate there is little incentive to clear the debt but move onto a higher rate and that can flip around
At present there is little incentive to pay down your mortgage quickly. You can even achieve higher rates on cash than the interest rate you are paying on your debt.
However, if and when that flips around it’s a potential trigger to pay down part of the mortgage.
When you come to remortgage that should be a consideration, taking into account mortgage rates at this point as well as your general financial position.
If the interest rate is not too high and repayments are comfortably affordable then investing your excess income has stronger appeal.
One factor that might tilt the balance in favour of that is if you can get a significant leg up on the money you put in. In this regard, paying into a pension could be particularly attractive.
Pension contributions benefit from tax relief which can boost your investment returns. Basic rate tax relief of 20 per cent effectively boosts the value of your money by a quarter, and for higher rate taxpayers there is effectively an even larger uplift on the net cost.
Some people use this strategy to help pay off their mortgage.
At present you can take up to 25 per cent tax free cash from a defined contribution pension such as a Sipp. If you have been benefitting from your own tax efficient contributions, as well as those of your employer along the way, this can add up to a handsome sum.
You also have the option of Isas on top, and for those under 40 a Lifetime Isa is also very tax efficient, albeit only a modest sum of £4,000 (to which the government adds £1,000) can be contributed each year currently.
You do need to bear in mind money in a pension can’t be accessed until a minimum age is reached. That’s 55 at present for personal pension schemes, but it is set to rise.
Bear in mind too that other pension rules, and tax relief, is subject to change in the future – and it’s worth monitoring the forthcoming Budget in this regard.
Rumours have been circulating about changes to pension tax relief and the extent of the tax-free lump sum that can be taken.
However, the overall tax efficiency of pensions should remain intact, and this can be an excellent strategy for paying off a remaining mortgage amount.
Based on historic returns from investments (albeit not necessarily a guide to the future!) it’s potentially the mathematically optimal route for lots of people.
However, the answer to this quandary doesn’t necessarily lie in a spreadsheet. Although investing may generate higher returns than a loan’s interest cost, markets also come with the risk of losses.
That uncertainty is a factor in itself. The peace of mind of lowering mortgage expenses and not having to worry about the performance of financial markets may outweigh the potential advantages of investing.
It comes down to priorities and, quite possibly, how different routes make you feel.
Although many people would consider it an inferior route from a mathematical perspective, prioritising a smaller mortgage over investing can make your financial position more resilient. It may give you greater control and more options, and it could reduce anxiety about an uncertain future.
Plus, when you overpay your mortgage, the debt will shrink and you will have more disposable income, which could fund contributions into pensions or other investments further down the line.
However, if you are happier taking risks, the power of compounding investment returns over long periods can be a hugely powerful force.
This is provided your investment strategy is sound, and you have a long enough runway ahead to deal with the inevitable volatility markets throw at you.