If you come into money from an inheritance, bonus or even a lottery win, your thoughts may immediately turn to paying off your mortgage. Although we live in a society where debt is commonplace and accepted, many people want to pay off their home loans at the earliest opportunity. After all, a home without a mortgage is financially secure.
But think twice. Instead of clearing or reducing your mortgage, consider your future. In particular, think about your pension provision.
You may be one of the millions of UK citizens who have an inadequate private pension. If so, consider putting your newly-acquired lump sum into a pension scheme.
The current average interest rate for a long-term mortgage is 4%. Your pension fund makes its money from the stock market. Average annual stock market returns for the past 90 years are around 7% ( most investors don’t even achieve half this return, see my earlier blogs). Paying into a pension could therefore make financial sense.
Check the facts
You need to treat stock market returns with caution, of course. Pension investment companies have varying success rates. Plus they charge a percentage fee of 1-2% for their services. You should always check these facts. Nonetheless, over a period of 20 years or so, you can expect your return from a pension fund to exceed your mortgage interest rate.
Consider your options
You should consider your options carefully, of course. By paying off some of your mortgage, you increase the equity in your property. This may help you obtain a lower interest rate if you remortgage and mortgage rates may increase from 5%.
But the main reason for being so bullish about paying into your pension is the considerable tax advantages this brings, especially for higher rate tax payers. The differential in interest rates and investment returns are not the main issue. Investment into a pension provides 100% tax relief. As a higher rate tax payer £80 paid into a pension provides a credit to your pension fund of £100 and also £20 deducted from your tax bill. Hence the cost to you is £60 for a guaranteed £100 return. 100/60 = 66% return on your investment. For a basic rate tax payer the guaranteed return is 25% even without any investment return.
So, the point is this, if you are lucky enough to gain a lump sum, don't rush into a decision about using it. Work out what you want and when. For many people, paying into a pension rather than paying off a mortgage can bring better long-term returns and security.
Chartered Accountant and Chartered Financial Planner