Two of the biggest financial challenges we face are paying off a mortgage and funding a comfortable retirement. But which should come first?
The natural preference for most people is “to pay off debt as fast as possible”, says Tom McPhail at Hargreaves Lansdowne. But assuming you’ve paid off non-mortgage debts, such as credit cards and personal loans, and you already have a decent level of equity in your home, then there is a strong case for prioritising your pension, says Thisismoney.co.uk’s Philip Scott.
That’s down to two factors: tax and inflation. The beauty of pension contributions for higher-rate taxpayers is that full tax relief on contributions means that for every £60 that goes in, £100 gets invested. Better still, provided the fund manager is half decent, then history suggests (judging by the Barclays Equity Gilt study) that you can expect an average annual return of 6.7% above inflation (less typical annual management fees of 1.5%).
Meanwhile, should inflation take off – and there’s every chance it might – your mortgage debt is naturally eroded in real terms each year. It was the runaway inflation of the 1970s that largely took care of “baby boomer” mortgages.
But even so, prioritising your pension over paying down anything other than a small mortgage is probably the wrong move. The price you pay for those pension tax breaks is inflexibility. Once paid in, you won’t see your money until at least the age of 50, and even then only 25% can be taken as tax-free cash. The rest must be used to buy an annuity. Although these rates have risen recently, they’re still not great – £100,000 buys about £7,000 a year from the best provider listed by the Annuity Bureau.
Then there’s rising mortgage rates. The average cost of Britain’s most popular deal, the two-year fixed rate, is already at a ten-year high of 6.75%. Anyone facing remortgaging from a much lower rate has every incentive to shrink their outstanding balance now, especially as lenders are heavily penalising anyone with a high loan-to-value mortgage. If you pay off £1,000 at 5.75%, rather than 6%, then you’ll be around £9,500 better off over 25 years. Even those with a decent equity cushion will see it shrink as house prices fall, and if you fall into negative equity you may not be able to remortgage at all.
There is a compromise: Isas. If you have a manageable mortgage but need to fund school fees, for example, before retiring, surplus cash (up to £7,200) should go into your equity Isa. That way your income and capital gains are protected from tax and you can access your cash anytime you need it.