Should you use your pension lump sum to pay off your mortgage?

This move could potentially free up more disposable income, allowing you to enjoy your retirement with fewer financial burdens. Additionally, the emotional comfort of owning your home outright and eliminating mortgage debt can provide significant peace of mind, making this option worth considering.

Fraught with potential pitfalls

However, paying off your mortgage early using your pension lump sum is fraught with potential pitfalls that require much greater evaluation. While the immediate financial relief is tempting, there are complex tax implications and long-term financial consequences to consider. For instance, withdrawing more than the tax-free portion of your pension can result in hefty tax liabilities, which might negate the benefits of reduced mortgage payments.

Moreover, depleting your pension fund early could compromise your retirement income, potentially affecting your quality of life in the future. Given these nuances, assessing your unique circumstances and seeking professional financial advice is essential to determine the best course of action.

Here are some key points to ponder as you navigate this significant financial decision.

Tax implications

You can access most workplace and personal pensions from age 55 (or 57 from April 2028) and use the money as you wish. However, while you can withdraw the first 25% as a tax-free lump sum (capped at £268,275 for most people), any additional withdrawals will be taxed at your marginal Income Tax rate.

If your 25% tax-free lump sum doesn’t cover your outstanding mortgage, making a taxable withdrawal to pay it off in full probably won’t make financial sense as it would trigger a range of additional tax considerations. It’s imperative to weigh the tax implications carefully before making any decisions.

Interest rates and mortgage payments

When interest rates are low, you’re probably better off leaving your money in your pension. This is because the potential growth rate in your pension is likely to be higher than your mortgage interest rate. There are some instances where paying off your mortgage might be the better option, so make sure you seek advice on what’s right for you.

When interest rates are high, it isn’t quite as straightforward. It may still be the case that your pension fund has the potential to grow at a greater rate and benefit you more in the long run than paying off your mortgage early would. It’s also worth remembering that most lenders only let you overpay your mortgage by 10% yearly.

Early redemption repayment charges

If you go over this amount while in a fixed rate deal, you might have to pay an early repayment charge (ERC) of between 1% and 5% of the outstanding balance. Before making any overpayments, make sure you check when your deal is due to end. Planning ahead can help you avoid these potential penalties.

Impact on retirement income

Taking money out of your pension to pay off your mortgage could have longer-term repercussions. A smaller pension pot will generate less income in retirement, which means you might be unable to afford the lifestyle you were hoping for or, worse, run out of money. This could far outweigh the short-term benefit of having lower monthly outgoings for a few extra years.

By using cashflow modelling, we can demonstrate how long your money will last in retirement and the impact that paying off your mortgage early would have on this. Withdrawing money from your pension could be especially detrimental during a stock market downturn.

Market fluctuations

If you sell investments that have fallen in value, you could deplete your pension pot more quickly than you anticipated. By leaving the money invested, your pension will have the opportunity to recover from dips in stock market performance and hopefully go on to produce a healthy and sustainable retirement income over the long term.

Exploring other options

If you do want to pay off your mortgage, there are other ways to fund this other than via your pension. Individual Savings Accounts (ISAs), for example, let you withdraw as much money as you wish tax-efficiently. ISAs also form part of your estate for Inheritance Tax purposes, whereas pensions typically do not.

Depleting ISAs before pensions could make sense if you want to leave a tax-efficient financial legacy for your loved ones. In a stock market downturn, however, withdrawing money from cash ISAs and savings accounts could be a better option, as you’ll leave your investments untouched and give them the chance to recover in value.

THIS ARTICLE DOES NOT CONSTITUTE TAX OR LEGAL ADVICE AND SHOULD NOT BE RELIED UPON AS SUCH. TAX TREATMENT DEPENDS ON THE INDIVIDUAL CIRCUMSTANCES OF EACH CLIENT AND MAY BE SUBJECT TO CHANGE IN THE FUTURE. FOR GUIDANCE, SEEK PROFESSIONAL ADVICE.