Should I Overpay my Mortgage or Pay into a Pension?

The answer to this question, like with almost all financial advice, is ‘it depends’.

Let’s look at the different things to consider…

Emotional Benefits

As William Shakespeare said; “neither a borrower nor a lender be.”

There’s a lot to be said in terms of emotional peace of mind from clearing debts, and in particular expensive consumer debts like credit cards and car loans. It’s one of the most important reasons why everyone should have an emergency fund.

Whilst it might be galling to have a few thousand euro sitting in a bank account literally earning no interest at all, the alternative is to run up a balance on your credit card or a personal loan.

Looking at the available credit cards available in the Irish market, even the lowest APR is nearly 14%.

So, remind yourself that your emergency fund is ‘earning’ you an interest rate of 14%, because that’s what you would pay if you had to put that unexpected bill onto your credit card.

You can modestly improve the actual return on emergency savings through creative use of State Savings.

Should I Overpay my Mortgage?

When it comes to mortgage payments the financial arguments can be more nuanced, especially if you have a cheap tracker mortgage.

However, generally speaking, if you have a large mortgage payment relative to your disposable income then paying down debt can make sense.

One of the reasons for this is the risk of rising interest rates. We simply don’t know what mortgage interest rates will average in the future. Obviously we don’t have a crystal ball, but if we look back into the past we can see that mortgage rates have tended to be much higher than they are now with the average since 1975 being 7.54% pa.

Source CSO.ie

So, if money is tight now, with historically low interest rates you are probably going to struggle if mortgage rates were to increase. Therefore, all things being equal, paying down debt will save you interest at the average prevailing interest rate over the remaining term of your mortgage (rather than just at the rate today).

This is an important distinction to make since an online mortgage repayment calculator will work out how much interest you will save based on your current mortgage rate. 

Should I Invest my Savings, Rather Than Pay Off my Mortgage?

Generally no. Let’s break down the arguments here

Remember that you pay your mortgage from earned income

This means that for any given mortgage rate, you need to work out how much of your gross taxable income you need to use to service the loan. In other words every euro of mortgage interest is being paid from your net income and therefore you need to gross up the mortgage rate at your tax rate in order to work out what it is really costing you to keep it.

The graph below illustrates the amount of gross income required to service a range of mortgage interest rates.

For illustrative purposes only

For example, a high earner paying tax at 52% with a relatively low mortgage rate of just 2% still needs to earn the equivalent of 4.16% before tax in order to service the debt.

So, that establishes our ‘break even return’ how much our investment needs to make on average after both tax and charges in order to see any profit.

My broker is recommending a 60/40 Portfolio

Over the last 5 years, the Dimensional World Allocation 60/40 Fund has averaged 6.46% pa not including distribution costs.

According to Zurich the distribution costs of this fund in Ireland are up to 2.05% pa.

So, let’s knock 1.5% from the Gross Fund Return giving us a return before tax of around 5%.

Exit Tax is applied at a rate of 41% (Tax Year 2021) so the net return on this strategy over the last 5 years has averaged approximately…

For illustrative purposes only

Compare this with the grossed up mortgage rates in the graph above and we can conclude that only those with extremely low cost tracker mortgages could ever expect to profit from such an investment strategy and even then there are no guarantees. Taking more investment risk could offer the potential for higher returns but also the chance of bigger losses.

Arguably, if you have a very cheap tracker mortgage and Capital Gains Tax losses that would allow you to invest virtually tax free, then you might give consideration to keeping the loan and making a more sophisticated investment but probably for most people the safest bet is to either reduce the debt or make a pension contribution.

So my choices are reduce the debt or make a pension contribution?

We noted above that mortgage payments are met from post-tax income. By contrast, pension contributions are met from pre-tax Gross Income.

So, the arguments in favour or making a pension contribution rather than paying down the mortgage are probably stronger and this is especially true for higher earners.

Example

Mary earns €100,000 pa and has a discretionary bonus from her employer of €20,000.

Her mortgage is €300,000 and the mortgage rate is currently 3% with 25 years remaining

Her options are:

1) Pay the bonus into her pension scheme

2) Take the bonus, pay the tax and reduce her mortgage.

Tax on Bonus

Source PWC.ie

We can see that the tax on the bonus is €10,400 leaving Mary with a net €9,600 to reduce her mortgage.

Again, using the Bank of Ireland over payment calculator we estimate that Mary will save €10,375 over the remaining term of her mortgage at current interest rates.

If we compare this with Mary paying the bonus into her occupational pension assuming a 25 year term and an average annual net return of 5%pa. Note we assume that Mary is not in danger of exceeding the €2m Standard Fund Threshold, an increasingly common problem for our clients.

For illustrative purposes only

So, under these assumptions, Mary would have incurred some additional interest costs over the term but is projected to have substantially benefited.

The tax on the bonus has been deferred, we like to think of this as an “interest free loan from Revenue” and the pension income is of course taxable in retirement but generally we pay less tax in retirement than when in work. Mary is also entitled to a lump sum in retirement of 25% of the value of the pension fund at of this the first €200,000 is currently tax free.

As we said at the start, as with many things, the right course of action is going to be specific to your individual circumstances. Please contact us to discuss your particular requirements.

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