Bonus episode: Should you overpay your mortgage or top up your pension?

The following is a transcript of a bonus podcast episode of The Pension Confident Podcast. Listen to the episode or scroll on to read the conversation.

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PHILIPPA: Welcome back. Now today we’re tackling a question a lot of you ask us. If you’ve got a bit of spare cash each month, where should you spend it? Paying down your mortgage faster or maybe topping up your pension? Mortgage rates have moved a long way from the ultra-low deals many of us got used to a few years ago, so you may be tempted to pay your mortgage down sooner. On the other hand, pension tax relief means the government effectively tops up whatever you put in. So, which one actually wins?

Here to help us weigh up the options is Maike Currie, VP Personal Finance at PensionBee. Welcome back, Maike.

MAIKE: Thanks, Philippa, great to be here.

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Inflation and interest rates

‍PHILIPPA: Now look, [the] rate of return is going to be right at the heart of any decision anyone makes about this, and at the heart of that we’ve interest rates, and at the heart of interest rates we’ve bank rate. What is [the] bank rate?

MAIKE: So, the first thing to remember about the bank rate is that it’s set by the Bank of England, the central bank of the country. Now, the easiest way to think about the Bank of England [is to] think about it as the manager of the British economy. And the manager’s job is to make sure that everything in the economy runs smoothly. And what the Bank of England needs to keep an eye on is inflation.

Now, inflation sounds like a complicated word, but basically all it means is price rises over time. The tool the Bank of England uses to control inflation is the bank rate. And think about this as the brake. When it raises interest rates, borrowing becomes more expensive for individuals and for businesses, and that slows things down a bit. It cools the economy down.

If the Bank of England wants us to spend a bit more, it will lift its foot off the brake and it will lower interest rates. If it wants to take some heat out of the economy when inflation is above its target - and crucially the target inflation where the economy’s not too hot or too cold is 2% - then it will increase interest rates.

Now the key thing to remember about inflation - price rises - is prices can rise even if the economy isn’t going gangbusters, and that’s because of external factors. And we’ve seen a lot of that in recent years from the COVID-19 pandemic. We saw it with the war in Ukraine. We’ve seen it with the war in Iran. So, these are external factors that we call ‘supply shocks’, and they’re pushing up prices, most crucially oil prices, which of course comes all the way down to the petrol pumps, what we’re paying for petrol and diesel. So, some of these ‘macro’ factors can very quickly find their way into our household spending.

PHILIPPA: OK, so where are we on inflation in the UK? Right now?

MAIKE: So, inflation in the UK at the moment is at 3.1%. It’s expected to increase over [the] coming months.

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Mortgage rates

‍PHILIPPA: Exactly. As you say, there’s so much of this stuff in the news right now, conflict abroad, energy crisis, all these things. Everyone’s talking about inflation, everyone’s talking about interest rates. And of course, interest rates, they impact your mortgage rate.

MAIKE: They do impact our mortgage rate. And it’s very important to remember that even if interest rates aren’t moving yet, so we haven’t seen the Bank of England yet increase rates in the UK as things stand. We’ve seen the US central bank, the Federal Reserve, increase interest rates. But even if the bank hasn’t moved on interest rates, our mortgage rates can increase. That’s because fixed-rate mortgages are based on something known as ‘swap rates’. And swap rates [are] really where traders think interest rates will go. So, the key message here is the bank can stand still, the bank rate can stay unchanged, but your mortgage rates can go up quite quickly.

PHILIPPA: So right now, where are average fixed mortgage rates?

MAIKE: So, for 2-year and 5-year fixed mortgage rates, the percentage is somewhere around the 5% mark -

PHILIPPA: and this is at the time I was recording this. Obviously, it might change -

MAIKE: of course. And as we mentioned, often mortgage rates can move even if the Bank of England stands still on the bank rate.

Tracker mortgages, so these are mortgages that track what the Bank of England bank rate is plus some fees. They’re slightly lower. There’s also a piece of mortgage jargon that we all should be aware of, which is called ‘SVR’, Standard Variable Rate. And this is really key, because if you’re coming towards the end of your mortgage [deal] and you don’t have your life admin in order, you’re going to go on to that Standard Variable Rate, and those are now somewhere near the 7% mark. So, it’s really important -

PHILIPPA: so much, much higher -

MAIKE: much higher. It’s really important to get your mortgage broker or mortgage advisor lined up and to have that conversation. Because the key thing also to remember about mortgages is that you can have the conversation and you can get that deal six months before you actually come to remortgage. So, if you’re on top of your paperwork, you can lock in a more competitive rate before rates move again.

PHILIPPA: Yeah, early planning can really pay off there.

MAIKE: Absolutely.

PHILIPPA: So where does that leave us then on overpaying? If you decide with this spare cash that you’re fortunate enough to have that you might like to throw some of it at your mortgage.

MAIKE: Well, the key thing to remember with most mortgage deals is that you can overpay mostly up to 10% of what you owe in a year. So, if you were thinking, “OK, well, my mortgage rate is still quite low now, I might overpay a bit because I can afford it”. You can only do that to 10% generally. You’ve got to be really careful about paying more than that because then you might get a charge.

PHILIPPA: What sort of money are we talking about?

MAIKE: Well, it depends. Between 1% and 5% [of the] overpayment [amount] and that could have a substantial impact.

PHILIPPA: Yeah. 

MAIKE: The other factor, of course, is how much time you’ve left on your mortgage. So, my guidance really, and this is something I do myself, is to make sure you download the app. Whatever mortgage provider you’re using, hopefully they have an app. You can log in and you can see what you’re allowed to overpay. 

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Pensions and tax relief

‍PHILIPPA: OK, so that’s the mortgage side of things. What happens on the pension side if someone thinks, “no, actually, I’m going to put my extra money in there instead”?

MAIKE: Well, the beauty of pensions that I always harp on about, but it’s really important to understand, is free money. With pensions, you get free money. What that’s, in essence, is tax relief. So, if I put money into a pension and I’m a basic rate taxpayer, so I’m paying 20% tax on my earnings, I’ll get a top up from the government to the value of 20%. So, that means I’m putting £80 into my pension, and the government is going to give me an additional £20 free, the free money. And in essence, I’ll then have £100 in my pension. So, what’s not to like about free money?

PHILIPPA: I mean, people are going to be listening to this thinking, “how is that possible? [The] government doesn’t do that.” Why do they do that?

MAIKE: Because they want to encourage us to put more into our pension. And I often talk to my friends about this. You put the money in and in a few weeks’ time you’ll see, as if by magic, that top up from HMRC into your pension.

PHILIPPA: It’s a lovely moment when you see that number. 

MAIKE: It’s a lovely moment. 

PHILIPPA: OK, so what about if you’re a higher rate taxpayer? Same deal?

MAIKE: Well, this is slightly more complex, but you’ll still get the basic rate tax relief top up, so you’ll still get that £20 into your pension. But if you’re a higher rate taxpayer, to get the full 40% in tax relief, you need to claim that back from the government, and you do that through Self-Assessment or through asking HMRC to adjust your tax code. So, it’s really crucial, especially as I’ve said before, in the UK, we’ve tax thresholds that resemble the Manhattan skyline. So, those huge cliff edges.

PHILIPPA: Yeah.

MAIKE: And if you can bring down your earnings by making that contribution into your pension, you could stay below the 60% tax trap, which often happens to people earning over £100,000. Sounds like a nice problem to have, but increasingly more and more people are being caught out by that. But equally, you can keep hold of advantages like childcare [tax relief], So, [it’s] really important to make the most of those pension contributions.

PHILIPPA: Chancellor John Healey has a big job on his hands with his first Budget, and it could affect you and possibly even your pension. Join us on The Pension Confident Podcast, where we’ll be keeping an eye on Westminster and explaining how any changes could affect you and your retirement savings. Subscribe on your favourite app.

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The longevity problem

PHILIPPA: OK, so we’ve kind of got both ideas on the table. How would you suggest people actually set about working out which one to prioritise?

MAIKE: I think there are some fundamental questions here, because when you’re paying down your mortgage earlier, you pay more on your mortgage versus putting money into your pension, you’re getting that certainty that you’ll eventually pay off your mortgage and you’re going to save on potentially the interest rate that you were paying every month.

PHILIPPA: Yeah.

MAIKE: But equally, as we’ve just spoken about at length, is when you’re putting money into a pension, you’re getting that free money from the government, that tax relief, and that really supercharges your pension. So, there’s little point in really sweating hard in your 40s and paying off the mortgage. And then when you reach your 50s, you realise, well, I don’t have enough in my pension because ultimately, your pension will fund your lifestyle. So, it’s a bit of certainty for the near term versus uncertainty in the long term.

Often, people look at what the rate is that they’re paying on their mortgage versus what they could potentially get from their investments. Of course, that’s never guaranteed. So, there are loads of things to consider. There’s also the psychological impact of having paid off your mortgage. It might mean you can sleep easier at night. But I’lll caveat that. If you’ve paid off the mortgage, right, and you’re saving on that monthly payment, what are you doing with that money? Are you putting it to good use? Are you investing it? Because if you’re just going to spend the money, you’re probably better off putting it in an investment.

Equally, there’s a lot of research out there that looks at people when they come to the point where they draw down their pension and they can access it at retirement age, they take that tax-free lump sum and immediately use that to pay off the mortgage. Again, I’d think very carefully about crunching the numbers, because could you be better off potentially leaving the money in there and your pension still growing over time? Because there’s a thorny word that we’ve spoken about on this podcast before, and that’s longevity.

PHILIPPA: Yes.

MAIKE: We’re probably going to live for longer than we think, which means we do need to supercharge growth in our pensions, we do need to keep them invested. So, it depends on the individual, really. It depends on that guarantee that you’ll pay less every month versus the promise of what return you could get. But generally, if we look at the MSCI Global [World Index], which is a benchmark of global stock markets, that return tends to be around 6%. So, it means even with mortgage rates now being around the 5% mark, which is quite high compared to what we were used to historically, you could possibly still get more growth with investing your money in a pension. And of course, you’re going to get free money from the government.

PHILIPPA: It’s interesting you say that because [of] this psychological point of, “I’m going to retire, I want to get shot of my mortgage”, and that’s quite a powerful driver. But as you say, longer lives and that sense of, “will there be enough money for me to enjoy all the active years I’m hoping I’m going to have?”

MAIKE: We’ve always been told that as you get nearer to retirement, retirement age, or if you’re in retirement, that you should start de-risking your pension. So, move from shares, equities, to safer assets like fixed income bonds and cash. But actually, we all still need that element of growth because of longevity and because of longer lives.

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Getting the order of priority right

PHILIPPA: Interesting. So, I mean, before people actually get to that decision of choosing between the two, is there a sensible order that they should perhaps review their finances in before they even start thinking about that decision?

MAIKE: Yes, absolutely. To build true financial independence and crucially financial resilience, there’s a sequence to how you manage your finances. And the first thing, of course, is to pay down debt. Now, there’s no point in saying, “yes, I’ve paid off my mortgage”, when you’re paying 20% interest on a nasty credit card.

So first and foremost, pay off debt. Distinguish between good debt and bad debt. Bad debt is that credit card and that loan with a sky-high interest rate. Good debt really is your mortgage or your student loan, which is something you’ve invested in to improve and enhance your life. So, pay off debt. Secondly, make sure you’ve got that fallback fund, that freedom fund, that -

PHILIPPA: Emergency fund?

MAIKE: Emergency fund, rainy day fund. You’ve got to have a fallback fund to deal with those short-term expenses like the boiler breaking or the car breaking down. So, pay off debt, make sure you’ve got your fallback fund in place, make sure you’ve got protection depending on whether you’ve got dependants, so you’ve got life insurance and all those factors in place. And then you can start thinking about, “Oh, I’ve got some extra money, I might want to pay off the mortgage, or actually I’m going to top up my pension and make the most of tax relief”.

PHILIPPA: Yeah, because if you’re still working, there may be advantages to be had in your workplace pension, right?

MAIKE: Oh yes. So, workplace pensions should rank right up there because I’ve spoken at length about tax relief and the free money from the government. But if you’re fortunate enough to be in formal employment, your employer will also be putting money into a pension via the workplace pension.

So now you’ve got your money going into the pension, the employer matching it, and make sure you find out what those minimums are that you need to put in to make the most of employer matching, and you get the tax relief from the government.

The one exception, of course, is if you’ve got money going in via salary sacrifice or bonus sacrifice, remember, you’re not going to see that surprise tax relief from the government because already the tax has been taken care of when the money goes straight from your salary into the workplace pension.

PHILIPPA: Got it.

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When to overpay your mortgage

PHILIPPA: So, I’m going to put you on the spot now because obviously this is a very - it’s a completely individual decision for everyone, just depends about a whole array of factors in their lives. But you, since you’re sitting here with me, how would you weigh them up?

MAIKE: Well, this is quite personal to me because I’m one of 900,000 households coming off my fixed-term mortgage. And I, as I do every time, I come off my fixed-term mortgage, I call my mortgage broker, mortgage advisor called Stuart. And I asked him for some guidance on all of this. And he kind of ran me through rates. And I was like, oh gosh, they’ve really gone up -

PHILIPPA: yeah -

MAIKE: since the last time we spoke. Can I sleep on it and just have a think about whether I want to fix [it] for two years or five years? And Stuart’s advice was, “don’t sleep on it, Maike. Rates are going up”. So, for me, the question really was, do I fix my mortgage for two years or do I fix it for five years? It does require me to predict what is going to be the future path of interest rates. And of course, interest rates, as we spoke about, being the tool to manage inflation in the economy, price rises. Now, inflation, the Bank of England wants inflation to stay on target, 2%. And the way to think about that 2% rate is that’s Goldilocks’ ideal porridge bowl. It’s not too hot, it’s not too cold, it’s just right. But it’s not just right, it’s too hot at the moment.

PHILIPPA: Yeah.

MAIKE: It’s a fair way above 2%.

PHILIPPA: Yeah.

MAIKE: Which means interest rates inevitably will have to go up. And the reason why that bowl of porridge is a lot hotter than it should be isn’t because our economy is booming, it’s because of those external factors. The war in Ukraine, crucially the war in the Middle East pushing up oil prices. Then we’ve got factors like the AI revolution and the idea that governments across the world will need to pay a lot more to build data centres. That’s going to be inflationary. There’s been talk in the Bank of England’s notes about the severe weather conditions we’re having right across the world, which has an impact on agriculture and the price of food.

So, not pretending to be an economist by any means, I’m just a mere personal finance commentator, but I see there are a lot of external factors beyond our control which is pushing up prices, which is making that porridge bowl really hot and steamy, and that will inevitably lead to interest rates going up. And I just want the certainty, Philippa. I want to know that for the next five years, this is what I’m going to pay. It’s going to be a fixed payment. And that enables me at this crucial stage where I am to put more money into my pension. Because I do want really the best of both worlds. I want the mortgage cleared and I want a nice healthy pension pot.

PHILIPPA: Interesting. Yeah, peace of mind definitely has a value. 

MAIKE: I think for me personally, a little bit of certainty is worth paying for.

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When to top up your pension

PHILIPPA: OK, that’s mortgage. What about pension?

MAIKE: So, with my pension, I, because I now know what I’m paying into my mortgage for the next five years, I can really plot my pension. I can really look at how much I should be putting in. Now, there are some rules of thumb as to how much you should be putting into your pension. It’s got to do with how much you’ve got in your pot.

But if you’re starting out, generally they say take your age, and half that, that should be the percentage you’re paying in. So, if I’m in my 20s, I should be paying in around 10% of my overall earnings. If I’m in my 30s, 15%, and so forth. I very much front-loaded my pension. When I was in my 20s, even though I wasn’t earning the biggest salary, I constantly put some money into my pension. So, I’m quite happy.

PHILIPPA: Impressive.

MAIKE: I’m quite happy with where it is. But again, as I say, we don’t know for how long we’ll live. We don’t know what our situation will be. We might have dependants coming and living at home, boomerang generation. So, I’m going to keep putting some money into that pension. 

When you’re faced with these big decisions, it can be easy just to fall into inertia, put your head in the sand because there’s just too much to think about. And you just hope that maybe it will itself out. I like to focus then on the things I can control. So, what are the things you can control? You can think about checking what your State Pension entitlement is, because again, that’s going to make a massive difference when you reach State Pension age. Quite easy to do. Look at how many years of National Insurance contributions you’ve paid and what State Pension you could be entitled to.

PHILIPPA: You do that online, can’t you?

MAIKE: You can do it online, and you’d be surprised at how few people actually know that they can do it. So, that’s an easy thing to do. The second thing is, over the course of our lifetime, we’re going to have several jobs. And we might have pension pots dotted about. It’s the nature of work. Our pension pot doesn’t move with us when we change jobs. So, think about whether you could consolidate those pension pots dotted about.

PHILIPPA: OK, there are a lot of inputs, a lot of things to think about before you make it. If you’re still struggling, thoughts?

MAIKE: If you’re still struggling, you could flip a coin. No, that’s never a good idea. If you’re really struggling between the two, why don’t you split the difference? If I’ve got a spare £100, £50 paying off the mortgage and an extra £50 in your pension. But I will say, Philippa, I’m really concerned that as we see these households come off record low interest rates and coming to remortgage, that’s going to mean our biggest bill, which is repaying the mortgage, increasing substantially. 

PHILIPPA: Yeah.

MAIKE: And I’m concerned that people will cut back on their pension contributions. And I’d be very, very careful about doing that. I’d rather cancel a few subscriptions, maybe Netflix or Apple TV or Amazon, than cut down on pension contributions because it’s so fundamental. And you’ll still be unlocking that tax relief, that money from the government that I keep harping on about, but it’s really one of the greatest perks of pensions.

PHILIPPA: And even if you do have to reduce your contributions, worst case, the key thing is not to stop, right?

MAIKE: Absolutely. Keep going, keep going, especially with the workplace pension, because you’ll get the employer contribution, you’ll get the money from the government. And the key thing is time is on your side. Because your pension money is locked away until retirement age, you’ve got time to make the most of compound interest.

PHILIPPA: Thanks very much, Maike. 

MAIKE: Thank you, Philippa.

PHILIPPA: Stay tuned for our next episode. We’ll be hearing Jonathan’s story of being on track to clear his mortgage before age 50 and what savers like you can learn from him.

And if you’ve missed an episode, don’t worry, catch up anytime on your favourite podcast app, or on YouTube, or if you’re a PensionBee customer, in the PensionBee app. Here’s a reminder before we go: anything discussed on the podcast shouldn’t be regarded as financial advice or as legal advice. And when investing, your capital is at risk. Thanks for being with us. We’ll see you next time.

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Risk warning

As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest. This information should not be regarded as financial advice.