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Mortgages versus Pensions

14 November 2023 Sector Insights, Investment Styles, About Alliance Trust, How to Invest Marcus de Silva

With interest rates so high, should I overpay my mortgage or top-up my pension?

Though not falling precipitously, the UK’s latest inflation figures are at least nudging in the right direction, with core inflation dropping 0.1% in September, to 6.1%.1 It’s why the Bank of England were able to continue holding interest rates steady in their latest get-together. No doubt, this is offering some relief for those with lofty interest payments. But moving forward, shifts are likely to be tentative: as is often the case in periods when central banks are fighting to tame high inflation, interest rates have a tendency to rise like a rocket and fall like a feather.

It means for many of us, the twin ravishes of inflation and high interest rates are continuing to put pressure on two of our biggest financial responsibilities: homeowning and retirement, where costs have ballooned. For mortgage holders, costs may increase beyond £500 a month this year2; for retirees, withdrawals may need to increase by up to £350 a month.3

It raises an interesting consideration: if you’re lucky enough to have some extra dollops of cash and seeking to get your long-term financial health into ship-shape, should you be over-paying your mortgage or boosting your pension? Let’s take a look at some different scenarios.

Which to do

New figures from stockbroker interactive investor (II) hypothetically compared the difference in the long-term wealth of someone with a £200k mortgage on a term of 25 years, who paid £200 extra into their pension each month (so £250 with tax relief) and didn’t prioritise their mortgage at all, versus someone else who paid the extra £200 into their mortgage first, before going on to add the extra into their pension later on.4 I have assumed the rate of interest stays the same given how inaccurate it would be to forecast.

When the interest rate is set higher than the rate of return from the stock market  6% vs 5% - the best outcome comes from paying off your mortgage first, as you might expect, with your wealth ending up £17,024 higher.

Likewise, when it’s the other way around, and you receive 6% stock market returns vs paying 5% interest, the best outcome comes from adding to your pension, leaving you £20,049 richer.

What’s revealing is when you make all things equal: setting the level of interest and stock market return at the same rate of 6%. In this scenario, you are left better off paying into your pension first, with your wealth £1,793 higher than if you were to pay off your mortgage first. In short, prioritising pension payments makes you richer.

How pensions can make you richer

The difference in favour of pension payments is explained by tax relief – the government’s tantalising boost to your retirement pot, which for higher rate taxpayers becomes even juicier given the potential for extra relief of up to 25%. If invested in a well-diversified global portfolio of shares, such as Alliance Trust, this can significantly boost your wealth over time due to the extraordinary power of compounded returns.

What’s more, investment trusts such as Alliance Trust have professional stock pickers at the helm seeking potential winners for the portfolio and are able to borrow extra money to invest, which may further add to gains over long periods of time. In addition, there are significantly fewer risks associated with investing in pooled investment products when compared to individual company shares.

Nonetheless, while prioritising pension savings may generously serve our financial well-being, we are human and psychology plays a big part when it comes to our finances.

Paying off your mortgage early liberates you of chunky monthly payments and offers peace of mind in the event your employment situation changes and the cash dries up. Moreover, it may leave you open to potentially better mortgage deals down the line.

All told, one happy solution might be to switch priorities over time: paying off more of your mortgage during periods of higher interest rates, and then boosting your pension when rates fall and the risk & return dynamic of stock markets become relatively more attractive.

Marcus de Silva is a Freelance Investment Writer

1. https://www.ons.gov.uk/economy/inflationandpriceindices/timeseries/d7g7/mm23

2. https://www.financialreporter.co.uk/a-million-mortgage-holders-to-see-monthly-costs-rise-up-to-499-this-year-boe.html

3. https://www.ii.co.uk/analysis-commentary/comfortable-retirement-costs-ps4200-more-year-2022-ii528939

4. https://www.ii.co.uk/analysis-commentary/overpaying-mortgage-or-topping-your-pension-which-will-make-you-richer-ii528817

This information is for informational purposes only and should not be considered investment advice. Past performance is not a reliable indicator of future returns. The views expressed are the opinion of Towers Watson Investment Management (TWIM), the authorised Alternative Investment Fund Manager of Alliance Trust PLC, and are not intended as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell any securities. The views expressed were current as at November 2023 and are subject to change. Past performance is not indicative of future results. A company’s fundamentals or earnings growth is no guarantee that its share price will increase. You should not assume that any investment is or will be profitable. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.  

TWIM is authorised and regulated by the Financial Conduct Authority. Alliance Trust PLC is listed on the London Stock Exchange and is registered in Scotland No SC1731. Registered office: River Court, 5 West Victoria Dock Road, Dundee DD1 3JT. Alliance Trust PLC is not authorised and regulated by the Financial Conduct Authority and gives no financial or investment advice. 

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