If you have extra money each month, what is best to do with it: pay off your mortgage or pay into a pension? For many UK homeowners, this is a big financial dilemma. Will they be better off clearing their mortgage early, or is it better to invest it into a pension for retirement?
So how can you work out what is best for you? The answer will depend on details like your mortgage rate, pension tax relief, retirement timeline, and your personal priorities. To help you decide, in this article we will compare both options, explain the maths behind them, and help you decide which is likely to leave you better off.
The quick answer
- Paying off your mortgage will give you a guaranteed return equal to your mortgage interest rate and reduces your debt and monthly outgoings.
- Paying into a pension gives you tax relief, potential employer contributions, and long-term investment growth, but returns are not guaranteed.
- If you are employed, a basic-rate taxpayer with employer-matched contributions, paying into your pension may be financially better over the long term.
- If your mortgage rate is high, your retirement date is close, or you value security and flexibility, overpaying your mortgage can make sense.
How mortgage overpayments work
When you make an overpayment on your mortgage – pay more than you need to – you reduce your outstanding loan balance. This means you will pay less interest over the remaining term.
The benefits of paying off your mortgage early
When you pay off your mortgage early you get a guaranteed return on your money. For example, if your mortgage rate is 5%, overpaying effectively gives you a risk-free 5% return after tax.
You’ll also reduce your monthly costs as you will be reducing your mortgage payments over time (depending on your mortgage), and removing them in full once it’s paid off.
For some people the security of owning their home outright, and being debt-free, is important to them. Being mortgage-free can give you an important sense of financial freedom – especially if you think of your home as your pension.
There’s less risk. Investing your money in a pension inevitably comes with some risk as you are reliant on the performance of the market. But paying of your mortgage is a a certain and immediate benefit.
The drawbacks of paying off your mortgage early
When you prioritise paying off your mortgage you are, in effect, investing your money in your home. The downside to this is it’s not quickly and easily accessible. If there’s a chance you may need money fast in future it might be better to invest it in an ISA or Premium Bonds instead.
In the last few years, mortgage interest rates in the UK have been lower than the returns people are achieving from their stocks and shares investments. So you could be missing out on higher returns.
If your mortgage is on a fixed-rate term you may face early repayment charges (ERCs) if you pay your mortgage off too quickly.
How pension contributions work
Pensions in the UK are designed to encourage long-term saving through tax benefits.
The key benefits of pensions
Here are some of the biggest benefits of paying into a pension:
- Tax relief: If you are self-employed and as basic rate tax payer, the government will top up your contributions by 25%. So if you add £100, they will contribute £25. And if you own a limited company, your pension contributions through it are an allowable business expense, which can reduce your Corporation Tax bill.
- Employer contributions: If you qualify for auto-enrolment, your employer must enrol you in a pension scheme and contribute a minimum of 3% of your salary. They may also match further contributions you choose to make.
- Salary sacrifice: If you choose to pay more into your work pension, the money comes from your gross salary, reducing your tax liabilities.
- Compound investment growth: Pensions tend to be a long-term investment, which means you can benefit from compound growth over many years (and even decades).
- Tax-efficient retirement income: You can withdraw 25% of your pension tax-free (up to a maximum of £268,275) once you reach the age of 55 (rising to 57 in 2028).
The drawbacks of pensions
Here are some of the downsides to investing your money in a pension:
- Investment returns are not guaranteed: Your money is at the mercy of the performance of your funds/the stock market.
- Access: The money you invest in your pension is locked away until you reach pension age.
- Uncertainty: Pension rules and tax treatment can change over time.
Mortgage payments versus pension – a simple comparison
Let’s look at a quick comparison of overpaying your mortgage versus investing in a pension. In this scenario you you have an extra £500 a month and a £200,000 mortgage at 5% interest.
| Option | What happens? |
| You overpay your mortgage by £500 a month | Your mortgage is paid off sooner and your interest costs fall significantly. |
| You pay £500 a month into your pension | With 20% tax relief, £625 goes into your pension. With employer matching, the amount could be even higher, and investments may grow over time. |
Over the past 20 plus years, pension investing has generally outperformed mortgage interest rates, but the outcome is uncertain. Mortgage overpayments give you a known saving.
When paying into a pension is usually better
Paying into your pension is often the better financial choice if:
- Your employer offers matching contributions. This is effectively an instant return that is hard to beat.
- You receive tax relief. A higher-rate taxpayer can receive even more relief, making contributions especially attractive.
- Your mortgage rate is relatively low. If your mortgage is around 2-4%, long-term investment returns may exceed that rate.
- Your retirement is many years away. The longer your money is invested, the more compounding can work in your favour.
When paying off the mortgage may be better
Overpaying your mortgage can make more sense if:
- Your mortgage rate is high. If your rate is around 5-6% or higher, the guaranteed saving becomes very attractive.
- You are close to retirement. Reducing or eliminating mortgage payments before you retire can improve your cash flow and reduce stress.
- You have already maximised your pension benefits. If you are already contributing enough to get full employer matching and remain within annual allowance limits, overpaying your mortgage may be sensible.
- You value certainty and peace of mind. Some people like the idea of knowing their home is fully paid for, and they don’t need to worry about finding money for future payments.
When you might want to overpay your mortgage AND pay into a pension
You don’t have to choose between paying off your mortgage and investing in your pension. If you can afford to, you can contribute enough to your pension to get full employer matching and tax relief and then use any extra cash to overpay your mortgage.
This gives you the best of both worlds by benefiting from pension incentives while still reducing your debt and interest costs.
How to work out which approach is right for you
To help you decide which approach is best for you, consider these questions:
- What is your current mortgage interest rate?
- Are you getting the maximum employer pension contribution?
- How many years are left until you retire?
- Do you have emergency savings outside your home and pension?
- Would you prefer guaranteed savings or potential higher investment growth?
Choose the best strategy for you
So what’s right for you: mortgage or pension? As you can see, there’s no one-size-fits-all when it comes to choosing between paying off your mortgage early and paying into your pension.
The best strategy for you will depend on your current financial position, and your appetite for risk/desire for financial security. But whichever you ultimately choose, you have the peace of mind of knowing you are making an investment in your future.
