The largest financial commitments you’ll ever make are to your pension and your home loan. But which should you prioritize in difficult circumstances like the present one?
As the cost of borrowing money continues to rise, homeowners are scrambling to pay down their mortgages early. The average fixed mortgage rate has increased dramatically. A lot of borrowers have been hit particularly hard this year as they made the switch from a low-cost fixed mortgage rate.
Large overpayments have been reported by borrowers to minimize the amount and interest paid prior to a rate increase. Would this strategy, then, endanger your retirement? Simply put, absolutely. It’s dangerous to withdraw money from a pension or retirement account.
To begin, you can lose out on employer contributions and tax breaks if you divert too much money from your retirement savings.
Paying down a mortgage or saving for retirement
So, how should you spend your extra money? There is no easy solution. Most people’s mortgages are the largest loans they’ll ever take out. Becoming “mortgage free” is empowering not just financially but also psychologically because it removes a major source of stress and uncertainty. The real cost of retiring, however, is often underestimated.
Middle-income private sector employees who contribute to a pension save less than eight percent of their salary. The expense of even a modest retirement lifestyle in 2022 will have skyrocketed due to soaring inflation.
To avoid the risk of having insufficient funds in retirement, most people will need to increase their pension savings. Many factors, such as interest rates, investment growth, and age, should be considered when deciding whether a down payment or retirement savings should receive priority.
Worldwide interest rates are widely believed to have reached their maximum level for the foreseeable future. It could be prudent to prioritise increasing your pension payments in this situation. A portfolio with a higher proportion of equities is likely to beat your mortgage over the long term, while a portfolio with a higher proportion of low interest rate bonds is not. This outperformance can have a significant impact on your lifelong wealth, but it’s difficult to calculate or envision when our cortisol levels are skyrocketing from experiencing immediate financial distress.
Case study
Let’s pretend you’ve got a €200,000 mortgage with a 25-year term and an average interest rate of 6%. You overpay your mortgage by €200 per month, on top of your required house loan and pension payments, until it is paid off in around 19 years.
You put away an amount equal to your mortgage payments plus an extra €200 per month into your pension for the remaining 6 years of the 25-year period (that would have been). Your supplemental pensions will have grown to €171,455 at the end of the 25 years, assuming average annual investment growth of 6% before costs.
However, if you put that extra €200 each year into your pension instead of your mortgage, you’d finish the 25 years debt-free and have a pension pot of €173,248 (using the same numbers).
That’s a difference of €1,790.
For the sake of simplicity, let’s say your government matched 20% of your pension payments at your personal income tax rate. This means that there is not much of a difference if mortgage rates, and investment returns are equivalent.
Investments and interest rates
To put it generally…
You should prioritize retirement savings (pension contributions) over paying down your mortgage if the stock market is doing exceptionally well, and its growth rate is higher than your interest rate. This is because, with time, your investments can grow in value.
However, if your mortgage interest rate is higher than the return you can expect from your assets, you may choose to focus on eliminating your mortgage debt first. So, pay down the mortgage first, and then start putting money away for retirement.
To put it another way, if you can save more for retirement through investments than you are losing on your mortgage, save for retirement first. If the cost of your mortgage is greater than the return you can get on your investments, paying off the mortgage should come first.
Since short-term performance should never distort calculations around long-term predicted returns, it is crucial to look at the expected annualized return of a portfolio. Although the medium- to long-term trend of capital markets is anything but flat, the experience of volatility within the stock market can feel flat from the perspective of an investor.
Finally, there’s the matter of taxes.
You should be wary of taxes if you intend to pay off your mortgage early and then increase your pension contributions as you approach retirement age. There is no hard-and-fast rule limiting the amount you can put into a pension each year, but doing so will cause you to forfeit some tax breaks and possibly incur additional fees.
To avoid paying taxes on your pension payments, your contributions for that year must be less than or equal to your earnings for that year. This tax cap does not, however, apply to employer payments to your pension.
Tax reductions on pensions might be a major consideration when deciding between saving for retirement and paying off a mortgage. If your taxable income is low and your mortgage is paid off, you may not be able to take full advantage of tax deductions for your pension contributions. In other words, when deciding which financial obligation to prioritize, taxes should not be ignored.
Waiting to increase your pension funds may not provide as much tax relief as you anticipate if you are in a higher income tax bracket.
Large pension contributions may become more costly in retirement if your income declines and you lose access to higher-rate tax relief. If your income diminishes over time, your retirement savings may become less tax-efficient.
Duration and potential danger
Your willingness to take financial risks and the number of years until retirement should inform your decision on whether to increase your contributions to your pension or accelerate the payoff of your mortgage.
You will need larger returns from your assets if you want to earn more than you would save by paying off your mortgage early. The stock market is a common source of these. However, keep in mind that this strategy is most effective if you are planning well in advance for your retirement years.
So, think about how long you have until retirement and how much you’re willing to risk financially.
The cost of retirement is rising because of rising prices. Pre-retirees should budget for rising costs of living, including those of food, gasoline, energy, and clothing.
The good news is that many have begun saving more for their retirement.
In summarising,
- Investing in a pension provides an immediate tax break, but making extra payments on your mortgage might free up cash for other uses, such as home improvements or a larger nest egg when it comes time to retire. Both choices are beneficial, but they accomplish distinct monetary ends.
- It’s a tough call to decide whether to put extra money into a pension fund or to pay off the mortgage early. Your age, the rate of inflation, and the performance of your investments are all factors.
- In addition to giving you peace of mind, paying off your mortgage early can help you save for retirement. You should, however, consider the impact on your retirement funds in the long run.
- You may not have enough money for retirement if you fail to make pension payments a priority. You’ll need a sizable pension fund, and the rising cost of living is a major cause for anxiety.
- It’s wise to strike a balance between retiring debt and keeping up with the mortgage. In this way, you can make the most of your investment prospects and tax advantages.
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