At a time of rising interest rates, many people may be considering whether or not they should overpay their mortgage or whether their money may be better off invested. We consider some of the pros and cons of overpaying a mortgage versus investing or contributing to a pension.
Everyone wants to do the right thing with their money. Once you have paid for your bills and household outgoings, put something towards pensions, insurance policies, savings and spent on nice-to-haves, what should you do with leftover cash?
Overpaying a mortgage or investing the money are two of the choices, but how do you decide which is better? Here are some of the things you should think about, but remember that every situation is individual and you should always seek professional advice before making any decisions.
Why do people choose to make mortgage overpayments?
A mortgage is a huge financial commitment not just because of the size of the loan but the length of time it takes to pay back. Twenty-five years used to be the standard term (or length) of a mortgage, but as property prices have risen, it’s more common now for younger people to have to take out a 30-year, 35-year or even a 40-year mortgage to buy a home.
The longer that’s left on your mortgage, the more you will benefit from making overpayments now to reduce its length. Every month you have a mortgage you’re paying interest, so overpayments shrink the amount outstanding and lower the overall amount of interest you’re charged.
Note that this is only for the most common kind of mortgage, called ‘repayment mortgages’. People with interest-only mortgages have special circumstances and should seek tailored advice.
There are also benefits when it comes to retirement planning, which we discuss in a moment.
Equally, if you have a relatively short amount of time left on your mortgage, are comfortable with the level of repayments you’re making, perhaps consider investing your spare cash elsewhere.
What are the drawbacks of overpaying a mortgage?
Plough your savings into your mortgage and you will not be able to access your money easily, without either selling your home or going through a potentially complex, long or costly process involving remortgaging or equity release.
Savings that are invested in an ISA or general investment account, however, can be withdrawn more easily. Nutmeg returns clients’ money in three to seven days and doesn’t charge for this, although it is worth noting than any used ISA allowance will be lost. (There is an exception with Lifetime ISAs, which have a government-set penalty charge, currently 25% for withdrawing money in most circumstances other than for the purchase of a first home or retirement).
Many people look at their home as an investment, but again there’s no guarantee that you’ll be able to sell it for more than you paid.
Why do people choose to invest?
Inflation diminishes the value of cash over time, so £5,000 today will have lower purchasing power in 20 years’ time. Consumer price inflation rose rapidly throughout 2022 and reached a 40-year high of 11.1% in October 2022. Although it has cooled slightly, in January 2023 consumer price inflation was still 10.1%.1
Investing in assets that rise in value over time can alleviate some of the erosion that inflation can cause, but there’s also a risk that the price of the investments fall and you lose money.
Although investing can appear more compelling when inflation is relatively high, investments should always be made with the long-term in mind. For example, a diversified portfolio of investments should be kept for at least three to five years and ideally longer, regardless of whether inflation falls during this time. This timeframe is necessary to allow the investments the ability to mature.
Remember, you should also keep aside cash savings of at least three months of living costs, which you can access quickly in case of any unexpected life events.
Should I overpay my mortgage or contribute more to a pension?
Most people have a workplace pension, or a private pension, opened independently of their employer. The money paid into pensions is invested, which is important to understand because many people don’t realise that they already have investments, through their workplace pension.
Money paid into a pension receives tax relief based on the individual’s rate of income tax. There’s a guide to understanding tax relief here, but in simple terms it’s an HMRC perk which means £80 contributed to a pension scheme is worth £100 to a basic-rate taxpayer while £60 contributed to a pension scheme is worth £100 to higher-rate taxpayers.
Tax relief can make small contributions to a pension significantly bigger, so it’s worth looking into whether you can make additional contributions to a pension.
Pension contributions are also potentially more valuable when they are made earlier in your working life, because there is more time for the power of compound returns to work their magic on your investments.
However, there is a limit to how much an individual can contribute each tax year to pensions, which is usually 100% of their pre-tax earnings or £40,000, whichever is lower. However, the specific amount depends on your individual circumstances, so take advice before making additional pension contributions.
How long do you have left on your mortgage?
When weighing up whether to put your spare cash towards a pension or your mortgage, consider how long you have left on your mortgage.
Previous generations could have expected to take out their first mortgage in their twenties and with a mortgage of up to 25 years, which meant owning a fully-paid up home in their fifties. At that point people are still working and can bump up their retirement savings by paying what would have gone to their mortgage into their pensions.
Soaring house prices have delayed home ownership and the average first-time buyer is now aged 31, with a mortgage that could run into their sixties or seventies. People in this situation will have fewer years of mortgage-free living to focus their efforts on pension saving. Making overpayments to your mortgage now could ease the burden later in life when planning for retirement becomes a pressing financial concern.
Is it better to overpay your mortgage or start investing?
Both overpaying your mortgage and investing can be good ways to make the most of spare money. Which one you opt for depends on your individual circumstances and there are pros and cons to each choice.
Making overpayments on a mortgage could mean you pay less interest overall and bring nearer the date when you are mortgage-free, which will free up more money to put towards investments, retirement savings and other life goals.
However, money paid into a mortgage is tricky to access without the complex and potentially costly process of remortgage or selling the property.
Investing can help your money rise in value and mitigate the eroding power of inflation, but there’s always the risk you lose some of your capital. However, cash paid into investments through an ISA or General Investment Account can be accessed at short notice – depending on the provider’s rules – although there’s no guarantee your investments will be worth what you hope they will on the day you need them.
Nutmeg’s Wealth Services team offer personalised restricted financial advice tailored to the individual. Whether you’re planning for retirement or want to ensure you’re managing your money in a way that’s optimal for your individual circumstances, book a call with the Wealth Services team today.
Risk warning
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Tax treatment depends on your individual circumstances and may be subject to change in the future.
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Annabelle Williams
Annabelle is personal finance specialist at Nutmeg. She is also the author of Why Women Are Poorer Than Men, which looks at economic inequality and gender. In addition to her interest in addressing the gender gap in savings, investment and financial outlook, she is interested in the role of socially responsible investing and the moves the industry is making to offer more ESG-focused investments to retail investors.Other posts by Annabelle Williams