Should I save into my pension or overpay my mortgage?
Q. I’m 32 and recently bought my first home in London. I have been paying 15 per cent of my salary into my workplace pension for the past three years but now that I have a mortgage I wonder whether it would be better for me to reduce my pension contributions and overpay my mortgage instead.
Like many first-time buyers, the only way I could afford to get on the property ladder was to take out a 35-year loan. Stretching the loan term made the monthly payments much more affordable, but I am aware that the longer the term the more interest I will end up paying overall. I have a fixed rate for two years and I can renegotiate the term if I am in a stronger financial position when the deal ends.
Tom Selby, the head of retirement policy at the investment firm AJ Bell, replies:
First, congratulations on buying your first home. Now for your dilemma of whether to pay off a mortgage more quickly or save for the long term.
You are wise to pay a high proportion of your salary into your workplace pension. Anyone over the age of 22 and earning more than £10,000 a year from one job is automatically enrolled into a workplace scheme. Most workers get the equivalent of at least 8 per cent of their salary paid into a pension pot, 5 per cent from you and 3 per cent from your employer.
Many employers offer more generous terms than the minimum, so make sure that you are making the most of any free money available. What’s more, once your money is in your pension, it can grow completely tax-free, although you’ll have to wait until you’re 55 to access your pot, with this due to rise to 57 in 2028.
You get upfront tax relief when you contribute to a pension. This means a £1,000 contribution is automatically boosted to £1,250 in a pension. If you’re a higher-rate taxpayer, you’ll be able to claim an extra 20 per cent tax relief from the taxman, while an additional-rate taxpayer could claim an extra 25 per cent.
The fact you get this upfront tax relief means that paying into a pension is likely to deliver greater bang for your buck than paying off your mortgage — although you’ll need to wait a few decades to access the money.
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Apart from paying into your pension scheme, paying off any big debts should be a priority. It would make little sense to overpay on a mortgage that charges, say, 5 per cent interest if your credit card debt is accumulating interest at 40 per cent.
If you don’t have any high-cost debts then consider establishing a “rainy day” fund in an easy-access account to cover emergencies like car repairs, or a new boiler. It is generally recommended to keep aside three to six months of normal household expenses. Websites like Times Money Mentor can help you to find the best-paying accounts.
Before you do consider overpaying your mortgage, check that your lender allows you to do this without imposing a penalty. Assuming there is none, then think about whether paying off debt makes better financial sense than investing the money. Are the returns you expect to get from investments higher than your mortgage interest repayments? If your mortgage has an interest rate of 5 per cent, then your investments would need to deliver returns of at least this amount after charges for the decision to pay off.
Emotionally, clearing your mortgage may seem more appealing but if you boil it down to pure finances then adding to your pension will usually win out.