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My specific situation is:-

  • Early 30s
  • Software contractor via a ltd company
  • Resident in Scotland
  • Higher-rate taxpayer
  • Mortgage at ~5% (variable 4.5% above BoE), LTV about 75%.
  • I'm allowed to overpay my mortgage by up to 10% in a calendar year
  • I'm working under the assumption that I'll be a basic-rate taxpayer at retirement

I'm trying to figure out whether I should be taking additional dividends to overpay that 10%, or instead put that money towards my pension.

As I understand it:-

  • If I take, say, an additional £10,000 dividend, I pay a total of 25% dividend tax, giving me £7,500 capital to put towards my mortgage. According to a mortgage calculator, that saves me about £17,500 in interest over the term of my mortgage, assuming that the interest rate stays constant.

  • If instead I put that money towards my pension, I am eligible for corporation tax relief at 20%, giving me £12,500 capital to put towards my pension. At retirement I can take 25% of that as a lump-sum tax-free, and then I pay the basic rate (20%) on the remainder pretty much regardless of how I draw it down giving me an effective marginal tax rate at retirement of 15%.

  • That means that to match my mortgage overpayment (worth £25,000) my pension contribution would need to be worth about £30,000 after 25 years, i.e. gaining about 3.5% annually.

Am I missing anything important in my calculation?

My unprofessional intuition in this case leads me to believe that paying down the mortgage is the better option:-

  • Less risky e.g. mortgage rate likely to go up, pension returns not guaranteed
  • More flexible e.g. if I want to retire early
  • Substantially less paperwork, giving me more time to do my day job
  • Doesn't incur the risk that the government will change the pension rules between now and when I retire

Is that a reasonable assessment?

Note: I intend to take professional advice before investing, but I want to be clued up before I do.

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    In America the answer is clear do not pay your mortgage early. we are paying about 4% here and we get to write off interest expense so now you are under 3%. I easily make more money in the market than 3%. Heck the last 20 years of my mortgage I could easily make more than 3% in a CD or bond. – Mark Monforti Jul 27 '14 at 13:46
  • Would you care to share the amount of mortgage you have left to pay (ie. the principal)? – Chris Jul 27 '14 at 14:40
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    @MarkMonforti sadly we don't get to write off the interest – Iain Galloway Jul 27 '14 at 19:21
  • @Chris It's about £230k. I was running the numbers through the calculator and strangely it didn't seem to make that much difference. – Iain Galloway Jul 27 '14 at 19:24
  • The remaining £230k is important as it determines the LTV. See my response below. Hopefully that is of use. – Chris Jul 28 '14 at 0:24
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None of what I say is advice directed to you. It is how I would continue to analyse the situation you have, were it mine.

First off, I prefer to work in certainties more than possibilities. Saying that, paying down the mortgage makes sense as I can calculate the amount I will save. I also believe that rate rises are coming in the future, based on the talk from the BofE, so any money I pay off now means guaranteed less interest to pay in the future. Also, the lower my loan-to-value ratio, the better/lower interest rates I can receive in the mortgage market.

If I do not want to work until retirement age, it'd be nice to have as few bills as possible in the decade or so prior to retirement age. I could then do early-retirement or part-time work in the run-up to retirement. I could use my savings to fund life until retirement pays out.

I'd be aiming to put 15% of my gross income into "future investing" - using ISAs to build up a savings pot, taking advantage of retirement products. That way all the money is not tied to a normal retirement age before it can accessed. And it's not touchable by future greedy Government taxation...

Any income leftover above the 15%, I'd be throwing at the mortgage - taking advantage of the 10% overpay window, remortgaging as LTV comes down. In theory, overpaid mortgage equity is money that could still be accessed (provided house prices don't decline and remortgaging is a possibility).

So, in short, I'd follow a plan along these lines of logic.

  1. Make sure I have 4-6 months of living expenses as a Rainy Day Fund. Insulate myself from fluctuations in my financial situation.
  2. Put away 15% of annual gross income towards "future saving". ISAs first, pension second.
  3. Overpay the mortgage and look to remortgage as LTV drops. When LTV nears 60%, look to lock in to a longer-term fix. eg. 2 year fixes at 90% LTV, 5 year fixes at 60%.
  4. Reassess steps 2 & 3 as life happens, circumstances change, work fluctuates, etc.
  5. Once the mortgage is paid off, build as much wealth as possible - ISAs first, then non-tax efficient savings products. Aim for keeping expenses down and raising my savings % rate as much as possible.

[Your analysis was thorough and shows you are thinking through consequences. Never forget to factor in the risk of carrying debt. Having no/low debt as you get older means there's more income left to build wealth. Ignore the American view of carrying debt for life and trusting investments to outperform the debt. You have to pay monthly to keep that debt around - and it ain't a pet!]

  • Yes of course it's true that you have to pay monthly to keep a debt. But if you have a choice between paying down £1 of debt or investing that £1, if the return on the investment is more than the cost of the debt, than it makes more sense to invest. If I am paying 5% on a debt and I can get 7% return on an investment, then if I invest the money, I can use the first 5% to pay the interest on the debt and I still have 2% left over. If you believe that an investment will return less than the interest on a debt, then by all means pay off the debt. – Jay Jul 29 '14 at 13:24
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    It's not the math of your argument that confounds me, it's the absence of risk. I'm unable to tell what my future will be. So two scenarios: 1) pay down mortgage 2) invest. Let's say we have a 10 year window. In (1), I could pay off the majority or all of my mortgage depending on my income level. After 10 years, I wish to change career to something less paid. My bills are lower so I can choose to do this. In (2), I have money invested, still have my mortgage but want to change career. Will I liquidate assets to pay off the mortgage? Doubtful. By paying off any debt, you give yourself options. – Chris Jul 29 '14 at 16:12
  • If you have invested in something liquid, then you could sell it off to pay off the mortgage. Why would it be a problem to liquidate an asset to pay off a debt, but it is not a problem to refrain from purchasing the asset to pay off a debt? To say you "doubt" you'd do that ... why not, if that's the rational way to accomplish your goals? – Jay Jul 29 '14 at 16:38
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    Can you liquidate a pension to pay off a mortgage before retirement age in the UK? – Iain Galloway Jul 29 '14 at 17:03
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    Simple answer - no. Even with the new changes coming in over the next year, you will only have freedom to access ALL the funds at retirement age. Who knows what will be the case in 20+ more years... I'm sure someone would lend to you on the collateral of a pension but I'd guess the rates would be unfavorable. Why not seek advice from a Financial Planner (or even an IFA) regarding these issues? Surely £300-500 would be a reasonable amount to pay for specialist, focused advice for such big decisions...? – Chris Jul 30 '14 at 8:20
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I'm an American so I don't claim to know anything about Scottish tax law. But just based on what you say above:

First, think about how it would work if there were no taxes. If you make a payment against the mortgage, you save 5% in interest. If you put money into a retirement account, you make whatever the profits are on the investment. If that amount comes to more than 5%, then you are better of investing in the retirement account. If it's less than 5%, you are better off paying off the mortgage. As most investments pay significantly better than 5%, this is the superior strategy.

On the other hand, apparently you are paying a variable-rate mortgage, but still, mortgage rates are relatively stable. Investment returns vary all over the place and can be negative. So if you are very cautious, that's a reason to pay off the mortgage rather than invest. The younger you are, the less of a concern this should be, as in the long term, investments pretty much always recover lost ground. If you were planning to retire next year I'd have very different advice than if you are planning to retire in 30 years.

But sadly, you do have to pay taxes, and that needs to be factored in.

So you say that you would have to pay 25% dividend tax on any money you used to pay the mortgage. But the effective tax rate on the retirement money is 15%. So in effect money put against the mortgage pays a 25% tax, and so effectively generates only 5% * .75 = 3.75%. But money invested in the retirement plan pays only 15% tax, and so if the investment returns 3.75% / .85 = 4.4% it would give the same effective return. So if you can invest in something that gives returns of at least 4.4% per year, you're better off putting into the retirement plan than paying off the mortgage.

There may be other Scottish tax implications I don't know about.

As to "Substantially less paperwork", I have no idea how much paperwork is involved in putting money into a retirement account in Scotland. Here in the U.S., you basically call a financial management company of one sort or another and say "hey, I want to open a retirement account with your company", and they'll prepare most of the forms for you and you just sign them. It could be done with half an hour of your time. Of course the more you research different investment options, etc, the more time it will take.

"More flexible e.g. if I want to retire early" If there are restrictions on when you can withdraw money from a retirement account and receive that 25% freebie you mentioned, yes, this could be a factor. Again, I don't know Scottish tax law, there may be other considerations. Here in the U.S., there's a 10% tax penalty if you withdraw money from a retirement account before the legal retirement age. Realistically that's a minor issue, if you have money in there for several years the tax benefits will be more than 10%. But yeah, it would be stupid to put money in in December and then take it out the following January and have to pay the 10% penalty.

"Doesn't incur the risk that the government will change the pension rules between now and when I retire" Maybe. But then laws might change in your favor, too. And as you indicated that your mortgage interest rate could change, there could be risk on that side too. That all comes down to what you think the risks are all around.

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    The differences between US and UK tax, mortgages and retirement make this answer largely inappropriate. It's a very well laid-out answer but it just doesn't fit with our situation. On a personal note though, the "better returns from market so stay invested" is an incredibly dangerous view that tends to be prominent in the US. I don't agree with the logic and find it worrisome that the message is being spread to non-US countries now. – Chris Jul 29 '14 at 9:23
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    Well, I said several times in there that I don't know Scottish tax law. But I tried to go by what the OP said the taxes were. Care to point out where I got it wrong? – Jay Jul 29 '14 at 13:26
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    It's not that your calculations were wrong, it's trying to draw parallels between the US and UK mortgage situations that falls down. The whole "invest and get better returns than your debt" is a very American viewpoint. It isn't widely held in the UK - and in my mind, this is a good thing. It's a similar argument to believing that 'top fund managers' can beat an index tracker. It's not a mathematical question, more one of common sense. Would you really find that 'top manager' and then monitor his activity? I know I don't have the time so I choose the market. Personal finance isn't just math. – Chris Jul 29 '14 at 16:19
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    So what's the flaw in the idea of investing vs paying off debt? Just to say, "this isn't very popular in the UK" could simply mean that a good idea hasn't caught on. It seems to me that simple arithmetic proves that it's a good idea. Sure, with all the usual caveats about uncertainty. – Jay Jul 29 '14 at 16:26
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    @Jay: Absolutely, but as a software contractor, a) the value of my time is unusually high, and b) my hours are unusually elastic. – Iain Galloway Jul 29 '14 at 20:54
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When I was a contractor I prioritize this way.

6 months salary nest egg while contributing to tax deferred retirement then after that you can pre pay your mortgage. Remember you can't skip a month even if you prepay. So once you pay that extra to your mortgage you lose that flexibility.

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    In the UK it's usually fairly simple to either release equity or arrange a "payment holiday" if you're ahead on your mortgage. On the other hand, I don't think I can get at my pension at all until 55 assuming the rules don't change between now and then. – Iain Galloway Jul 29 '14 at 21:06
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In general, saving money should be prioritized over extra debt payments.

Every dollar that you spend paying down a debt will decrease the amount of principal owed; this will directly decrease the future interest payments you will make. However, as time goes on, you are dealing with a smaller and smaller set of principal; additionally, it is assumed that your income will grow (or at least keep pace with inflation), making the debt more bearable.

On the other hand, every dollar you save (or invest) now will increase your future income - also making the future debt more bearable. Not only that, but the longer you save, the more value to you get from having saved, meaning you should save as early as possible.

Finally, the benefits of paying down the mortgage early end when the mortgage is completely paid off, while the benefits of saving will continue (and even grow) after the house is owned free and clear. That is, if you have an extra $100,000 to put into the mortgage during the life of the loan, you could sink that into the mortgage and see it disappear, or you could invest it, and reap the dividends for the rest of your life.

Caveat emptor: behavior trumps numbers. This only works if you will actually be disciplined about saving the extra money rather than paying off debt. If you're the kind of person for whom money burns a hole in your pocket until you spend it, then use it on debt. But if you are able to save and invest that money, you will be better off in the long run.

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    I don't think your logic is sound there. If I put £100,000 into my mortgage, that money doesn't "disappear". It means £230,000 that I don't need to pay later! – Iain Galloway Jul 31 '14 at 15:54
  • Ask yourself this question: are you better off with $1,000 invested and $1,000 in debt, or $1,000,000 invested and $1,000,000 in debt? In the second scenario, you have a much greater income which will only grow over time, while your debt decreases. – Benjamin Chambers Aug 5 '14 at 2:54
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I'm also a UK, Ltd company contractor that has pondered the same topic.

I afraid, however, that I don't understand the maths in the original question. Mortgage interest is flat for the term of the mortgage rather than compounded, so, ignoring the tapering at the end of the lifespan of the mortgage, I get the amount of interest to something like £9,300 (7500 x 0.05 x 25). Does this make the decision any easier for you?

As you point out, the total cost of this overpayment from your company account is £12,500. Using the above figure, it would take over 13 years to recoup the £5,000 difference (at £375 interest a year).

I used to be of the same opinion that the mortgage should be paid off at all costs first. But now I'm coming round to the American way of thinking; £12,500 invested in a pension with a 5% yield will easily outstrip the interest saved by making the over payment - 12500 x 1.05 ^ 25 = £43,300 - over 250% better off (£43,300 / (£9,300 + £7,500)).

I now make no mortgage overpayments at all and instead pay all the money into my pension. This (amongst other things) keeps me below the upper earnings tax threshold, so I'm only paying corporation tax for the money I'm drawing as dividends. There's a massive caveat to this though; I'm 49. I should be able to draw the tax free element of my pension pot in six years time and pay my mortgage off and it's quite unlikely that the government will be changing pensions policy in that time (but drawing 25% tax free has been a feature of pensions for quite some time). I can then chose to keep working or retire. If my pension is still doing well (9% ish pa at the moment), I could chose to not pay my mortgage off at all. In the next twenty or so years, however, all this could change.

In your position I would do a bit of both. Make a regular overpayment to pay down your mortgage (even a small amount that you'll barely notice will make quite a difference to the end date of your mortgage - £100 a month will take years off). I didn't start paying properly into my pension until fairly recently and so If you're not already, I'd also make quite substantial, regular payments into one now, directly from your company, 15-17.5% of your gross drawings. Leaving it until later will only make it more painful. Then when you get to retirement age, no matter what, you'll have a decent pension pot. An actuary I worked with pointed out that if you pay something into a pension, when you retire you should have some sort of pot; if you pay nothing, you are absolutely guaranteed to have nothing.

And finally, if you haven't already, fix your mortgage. We're three years into a five year fix. The variable rate we were going to be transferred to was 3.99%. We fixed, not because of wanting any sense of security, but because the fixed rate was 2.59% with no fee. There are much better rates than that about now. Rates are starting to rise, so it's a good time.

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    Mortgage interest is compounded; it's the payments that are flat over the life of the mortgage. – Ganesh Sittampalam May 28 '15 at 12:21
  • The mortgage interest does get compounded, because you're paying interest on a smaller outstanding balance, and then not paying interest on the extra interest, etc, etc. – Iain Galloway May 28 '15 at 13:59
  • Similarly at the other end, you've got £43,000 in your pension pot, but while you get to take a 25% lump sum, you have to pay basic rate income tax on the rest when you draw it down. – Iain Galloway May 28 '15 at 13:59
  • But yes, if you assume guaranteed 5% return on pension pot vs a cheap 5-year fixed rate, the pension comes out ahead. At that point it kind of becomes a subjective decision about how much risk you're prepared to take. – Iain Galloway May 28 '15 at 14:01
  • I'm not sure I follow the argument. If the principal is £1000 and the interest rate is 5% and I pay £50 keeping the principal the same, how is the interest compounding? If I paid £20, there would be an extra £30 and I would then pay 5% interest on that. That was my understanding of how compound interest worked. Payments are flat over the course of the life of the mortgage to pay off the interest and a little bit of the capital, the flat payments have more effect towards the end of the mortgage as the outstanding balance gets smaller. – birtwistler May 28 '15 at 15:03

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