How can £50 a month in spare cash have the maximum impact on your finances?
If you’re lucky enough to have a little spare cash floating about, what should you do with it? Should you overpay your mortgage or top up your pension?
Of course, it’s sensible to clear your debts before you think about investing. But I think it would be crazy to put-off your pension until you’re mortgage-free. After all, what pensions love most is plenty of time to grow. So I’ve done a little number crunching to see which route really does make more sense.
Overpaying your mortgage by £50 a month
Firstly, you’ll need to check your lender allows you to make overpayments. Most lenders do.
To calculate how much you could save by overpaying your mortgage, I’ll need to make a few assumptions. These are:
- Your mortgage loan is £150,000 which you have borrowed over 25 years.
- The mortgage interest rate is 7%.
- The savings made don’t take inflation into account.
So, let’s compare the difference between sticking with your original repayments and making overpayments:
Original repayments at 7% | With overpayments at 7% |
|---|
Monthly payment | £1,060.17 | Monthly payment | £1,110.17 |
Total amount repaid | £318,050.64 | Total amount repaid | £296,222.09 |
Term | 25.0 years | Term | 22.2 years |
Saved years | - | Saved years | 2.8 years |
Saved interest | - | Saved interest | £21,828.55 |
As the table shows, by overpaying your mortgage by just £50 a month you could save almost £22,000 in interest and cut your mortgage term by 2.8 years. Now let’s look at what would happen if you decided to top-up your pension instead.
Topping up your pension by £50 a month
Let’s say you pay £50 a month into a pension for the next 22 years. Remember by overpaying your mortgage by £50 a month the term could be reduced from 25 years to just over 22 years as we have just seen. So to make everything equal, I’ll assume that’s how long you pay into the pension too.
Don’t forget that pension contributions qualify for tax relief, which effectively means you’ll get back the tax that has already been deducted. This can then be invested in your pension along with your own contributions.
With 20% basic rate tax relief, a pension contribution of £50 turns into £62.50. (If you’re a higher rate taxpayer you’ll be eligible for tax relief at 40%).
To work out how much your pension will be worth in 22 year’s time, again I need to make some assumptions. Here they are:
- Your pension grows at 7% a year.
- Pension charges of 1% p.a. are deducted.
- The pension fund value doesn’t take inflation into account.
So, after all that, this is what your pension could be worth:
Monthly Contribution | Projected fund value after 22 years at 7% p.a. |
|---|
£50 (plus tax relief at 20%) | £33,300 |
If we think about the decision from a cash perspective only, your pension could grow by almost £11,500* more than you would save in interest by overpaying your mortgage. (*That is £33,300 - £21,828.55.)
But the decision isn’t quite that clear-cut. Here are some other factors you should also take into account.
Pension growth and mortgage interest
What if your pension grows at less than 7%? Or your mortgage interest rate is more -- or less -- than 7% on average over the term?
I redid the figures assuming the mortgage interest was 9% and not 7%. This time, you would actually be better off going down the mortgage route:
Original repayments at 9% | With overpayments at 9% |
|---|
Monthly payment | £1,258.79 | Monthly payment | £1,308.79 |
Total amount repaid | £377,638.36 | Total amount repaid | £343,845.72 |
Term | 25.0 years | Term | 21.9 years |
Saved years | - | Saved years | 3.1 years |
Saved interest | - | Saved interest | £33,792.64 |
Likewise, if your pension only grew at say 5% a year -- instead of 7% -- then again it may be a better bet to clear your mortgage early rather than stock up your pension fund.
Inflation and tax
The figures shown don’t include inflation so the amounts saved on your mortgage or accumulated in your pension fund would actually be reduced in real terms.
What’s more, 75% of the pension fund will probably need to be converted into an income using an annuity when you retire (as per current pension rules). The income from an annuity is taxable under normal income tax rates, so you will need to think about that deduction too.
Certainty
There are no guarantees but I think it’s safe to say once you reach the end of your mortgage term your debt should be repaid and the property is all yours. You may think the sooner that day arrives, the better.
But the same guarantees don’t come with a pension. The fund itself isn’t directly available to you. Most of you will only be able to take pension benefits using an annuity. Don't forget your annuity normally dies with you. If you don’t survive for very long after buying the annuity, then the lion’s share of your pension will be lost and all the extra top ups will have been wasted.
Access
You can’t access money from your personal pension fund until you reach 50 (or 55 from 2010). While this means you can’t fritter cash away, your money could be locked away for a very long time. However, by overpaying your mortgage you would build up a reserve over time, which means you may be able to underpay later on if you fall on hard times.
Mortgage options
The Foolish approach would be to remortgage several times before your debt is cleared. As you know, the credit crunch has forced many lenders to tighten up lending criteria. These days borrowers with more equity in their homes tend to qualify for better remortgage deals. So there’s a strong argument for paying down your mortgage as soon as you can.
As with most financial dilemmas, there isn’t an easy solution. You’ll need to find a way clearing your mortgage and planning for your retirement. Of course, you may intend to use your property to finance your twilight years, rather than going down the traditional pension route. But that isn’t clear cut either. Read more about it in my recent article: Don’t Rely On Your Property For Your Pension.
More: This Mistake Your Wreck Your Retirement | How To Find The Cheapest Mortgage. If you need a mortgage or remortgage speak to an independent broker at The Motley Fool Mortgage Service.
