What to do with a lump sum

Saturday, 30 August 2008

If you were to receive a lump sum, would it be wiser to pay off your mortgage or invest it into a pension?

Gut reaction may tell you that it is better to pay off your debts than to invest the money, so you would think about using the money to pay off at least part of your mortgage. When you’re looking towards retirement these are important considerations.

However investigation into the subject has shown that you could be better off putting the money into your pension instead. As an example, one thousand pounds invested into a pension gives a £548 better return than using the same amount toward a mortgage with an interest rate of 6%. Remember also that many mortgages have penalties attached to them if you pay off more than the regular amount and could be another reason to target this money in the direction of your pension pot.

There are also other considerations. If your mortgage is at a high loan-to-value – in other words if the value of your mortgage is close to or even higher than the value of your home – then you would probably be better advised to pay off a chunk of your mortgage to guard against further property falls.

Two key factors mean that pensions can out-perform mortgages. These are tax relief and inflation.

For every £1,000 invested into a pension, you get £250 basic tax relief added to it, and higher rate tax payers can get even more.

In addition, a mortgage is a fixed payment, meaning that over a reasonable period of time the payments will tend to be reduced in real terms due to inflation eroding their value. However pension funds should see a growth of their funds, hopefully beating otherwise at least reducing the effects of inflation.

Ironically, the lower your mortgage interest rate, the less you will save in paying off some of the mortgage capital.

Overpayment of £1,000 would save £1,568 over 25 years on a mortgage at 6%, and inflation assumed to average 3%. However the same amount paid into a pension with average annual growth of 6% would rise to £2,116 over 25 years for basic rate taxpayers. Higher rate taxpayers could see the pot rise to £2,366.

Thus, basic rate taxpayers would gain £548 more for using a pension fund than paying off their mortgage.

Overpaying a mortgage does bring earlier returns. Pension funds cannot be accessed until age 50 (55 from 2010) and 75% of the value must be turned into an income. When you pay off a mortgage the interest saving starts almost straight away and value of the capital repayment comes at the end of the term.

In conclusion, the current economic circumstances suggest that it is better to invest the lump sum rather than pay off a mortgage. The benefits by the time you are over 50 are evident.


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