If you have some spare cash left over at the end of the month, are you better off devoting it towards overpaying your mortgage or topping up your pension pot?
Mortgage borrowers are under ever greater pressure, with the Bank of England having hiked the base rate yet again to its new level of 5.25%.
As a result, the typical interest rates for two-year fixed rate mortgages are above 6%, according to data from Rightmove, with rates expected to remain high for the foreseeable future.
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These higher borrowing costs have had a noticeable impact on the housing market, slowing down transaction levels and leading to house price falls as prospective buyers opt to bide their time.
What’s more, millions of households are yet to feel the pain of rising rates on their mortgage repayments, as their fixed deals are yet to come to an end.
If you're still on a cheaper deal with a fixed rate yet to conclude, or if you have some extra cash, you may be wondering if it's a good idea to overpay your mortgage now.
But is this a good use of cash or could you get a better return in the long run with other assets?
New analysis from interactive investor has the answer.
Should you overpay your mortgage?
“After a long period of ultra-low interest rates, many of us are facing a dilemma in 2023,” says Alice Guy, personal finance editor at interactive investor.
“Interest rates are on the rise and thousands of us on fixed mortgage deals are frantically overpaying our mortgages before they’re due for renewal at a higher interest rate.”
“But we also know that, in the long run, many of us need to boost our pension contributions to help us achieve a big enough pot for a comfortable retirement,” Guy says. “Leave those pension payments to the last minute and we’ve less time for investment compounding to boost our wealth.”
Ultimately, deciding whether or not to overpay your mortgage comes down to your personal financial situation.
When should you start overpaying your mortgage?
Anyone thinking about overpaying on their mortgage should first pay down expensive debt, such as credit card bills, overdrafts or store cards, says Laura Suter, head of personal finance at AJ Bell.
“Once that’s done you need to build up a cash buffer to cover between three and six months of expenses to fall back on if you hit an expected financial bump in the road.” With interest rates rising, there are a growing number of highly competitive savings accounts on the market.
After that, you need to check that your mortgage provider allows repayments. Some might limit overpayments to a percentage of what you owe, while others might charge early repayment fees.
You also have to decide how much you can afford to overpay, and whether you want to overpay monthly or as a one-off.
“Overpaying each month, even if it is as little as £100, will likely save you money in the long run,” says Brian Murphy, head of lending at Mortgage Advice Bureau. “It also offers you more flexibility if you come into a situation where you need that extra cash - you can simply lower your payment to the pre-agreed fee.”
“Paying in one large lump sum will likely help you clear the mortgage faster and will certainly reduce the interest you are paying. However, if you suddenly need that extra money back, you won’t be able to withdraw it from the mortgage, so only do this if you know you won’t need that money.”
“To release that equity again you would need to re-mortgage or take out a second mortgage, which can be much more expensive,” says Suter.
Still, with the cost of borrowing rising, paying down any outstanding debt does make a lot of sense, even if you’re on a fixed-term deal.
“The lower your balance, the less this rise in interest will affect you,” says Becky O’Connor, director of public affairs at PensionBee. “So actually, by increasing your mortgage payments, you would also be preserving your ability to increase your pension contributions in future, too, by reducing the overall burden of mortgage interest on your finances, all other things being equal.”
The benefits of overpaying your mortgage
Paying your mortgage off faster than planned will reduce the amount of interest. With an interest rate of 3%, someone who borrowed £200,000 over 25 years would pay £948 a month. Overpaying by £200 a month would save you around £21,620 in interest and see you pay your mortgage off six years earlier than planned.
Someone with the same mortgage on a 6% interest rate could make a saving of £32,017 by overpaying £100 a month.
It’s also worth thinking about options that will open up later on – such as downsizing. Trading a larger home for a smaller one could leave you with extra cash you can use towards paying off the remainder of your mortgage.
Should you prioritise pension contributions?
If you decide to overpay, it’s important not to compromise your pension contributions. Indeed, there are many reasons why putting extra money into your pension might make more sense.
“Money put into a pension benefits from tax relief and also benefits from often being invested in the stock market for a long period of time, enjoying the magic of compound interest and the possibility of riding out any volatility in the markets,” says Karen Noye, mortgage expert at Quilter.
The early years of saving for retirement are important due to the effect of compound interest, or the interest you earn on interest. By prioritising mortgage contributions earlier on in life, you could be giving up valuable investment growth.
“Most pensions will grow between 2% and 3% a year which might not seem like much, but over a long period and with a larger amount in the pot, this does add up,” says Murphy from MAB.
Additionally, even though mortgage rates will remain elevated in the short-term it's likely they will come back down. So, it might not make sense to put all of your extra cash towards your mortgage.
“Investing in the stock market has historically given the greater return particularly when invested via a tax-efficient product like a pension,” says Noye.
“Therefore together the power of tax relief and fund growth over a long-term horizon may make it better to allocate additional funds to your pension especially if you are paying more than just the basic rate tax.”
MORTGAGE OVERPAYMENTS VS HIGHER PENSION CONTRIBUTIONS
A new study by interactive investor runs through a number of scenarios, crunching the numbers on the question of prioritising mortgage overpayments or pension contributions.
The table below details an example of someone with a £200,000 mortgage, over a 25-year term, with a spare £200 each month and on the basis interest rates remain static.
Here’s how the money would change their potential outcomes depending on whether they focused on mortgage overpayments first, or went straight to pension contributions.
The table below shows extra pension wealth after 25 years:
| 6% interest rates, 5% investment growth | 6% interest rates, 6% investment growth | 5% interest rates, 6% investment growth | ||
|---|---|---|---|---|
| Option 1 | Overpaying mortgage first and then pension (with tax relief) | £165,901 | £171,455 | £152,758 |
| Option 2 | Paying into pension first | £148,877 | £173,248 | £173,248 |
| Option 3 | Overpaying mortgage first and then pension (no tax relief) | £132,720 | £137,164 | £122,224 |
| Difference between options 1 & 2 | £17,024 | £-1,793 | £-20,490 |
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
As Alice Guy notes, the reality is that interest rates do not remain static, so at different points it may make more financial sense to focus on either mortgage overpayments or pension contributions.
The role of tax relief on contributions is also a crucial consideration. Guy says: “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.”
THE VERDICT
As with all financial matters, there is no straightforward answer. What you do will depend on your priorities, circumstances and appetite for risk.
If you think ultra-low mortgage rates might make a comeback in the near term, then putting the money towards your pension and letting interest compound might be more appealing than paying your mortgage off quickly.
If you think you might need this extra cash for any reason in the near term, then keeping it somewhere you can access it easily will make more sense.
If you want to prioritise paying your mortgage off early so that you know it’s one bill you don’t have to worry about later on, or just because you want to tick it off your list of goals, then that might seem like the obvious choice.
Things such as your mortgage term, interest rate, age and job status will also factor into the equation. “It is therefore key to weigh this all up and it is best to speak to a professional financial adviser who can help you navigate these variables and get the best possible outcome for your unique financial situation,” says Noye.
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