For many people chasing financial independence, clearing the mortgage ASAP is a key early retirement milestone. And if that’s your plan, then the notion of paying off your mortgage with your pension instead might sound painfully slow.
But have you actually run the numbers?
Recently, I’ve been considering moving to a more expensive house.
There’s a snag, though: I won’t be able to pay down a larger mortgage over 25 years. Or even over 30 years. Not without stopping my ISA and pension investments, anyway.
And I’m not willing to give up on my laissez-FIRE [1] early retirement dreams just yet.
I’ve realised though that I don’t necessarily need to pay off that bigger mortgage. I just need to service the debt while living in the house for as long as we want the extra space.
Once our kids have grown up – and their vacated rooms begin to suck in exercise bikes, old books, forgotten toys, and a ton of other clutter – then I can sell it.
At the same time, when my kids have grown up… well, I’ll also be eligible to access my pension if I want to.
Which is a slightly scary thought. But it does come with some side benefits.
It’s not the prospect of a free bus pass that I’m excited about. Rather, it’s the possibility of using my pension to pay off my mortgage.
I’ve done my sums, and I think this could potentially save me 50% on my mortgage payments.
And what old age pensioner doesn’t love a chunky discount?
The mechanics of taxation are key
Tax is simple in theory. But when you get into the weeds of gross and net payments, it can start to feel a lot more complicated.
Roughly speaking, if someone earns £60,000 gross, then they receive roughly £45,000 net into their bank account, after tax, under the current tax regime.
So if they choose to use £450 of their bank account cash to overpay their mortgage, it has actually cost them £600 of their gross earnings.
Most of the time this doesn’t matter. Feel free to stand at the counter in Costa Coffee and point out that your £4.50 coffee actually cost you £6 in gross earnings. I doubt the rest of the queue will care too much.
With pensions, though, it matters tremendously.
That’s because pensions – both defined benefit and defined contribution – allow you to mitigate and/or delay your income tax bill.
How pensions work
I won’t dive into how defined benefit pensions work, because you could easily write a book on the topic. But the principles with respect to taxation are similar.
I’ll just use defined contribution pensions as the example today.
The central point:
- If you’re in, say, the 40% income tax bracket [2] and you decide to put £1,000 into a pension, then that money goes in free of all income tax.
That might be because your company puts money into your pension before even subtracting any tax – so-called salary sacrifice. In this case, you now have £1,000 in your pension instead of £600 in your bank account.
Alternatively, you can transfer taxed cash into a SIPP, get an automatic 20% top-up from HMRC, and then claim another 20% back on your tax return.
Either way, for now you’ve avoided paying 40% marginal income tax on that £1,000.
However it’s very hard to say precisely how much tax you’ve saved by moving money into a pension in the long run.
It’s not just income tax you need to consider
For instance, at earnings of £60,000 to £80,000, with children, you might need to pay the High Income Child Benefit Charge [3] (HICBC):
- The HICBC could put up your effective marginal tax rate to 57%.
- At earnings of £100,000 to £125,140, you’d face a higher marginal tax rate [2] of 60%.
- With children in nursery, the withdrawal of support [4] can mean effective rates above 100%.
You’re also paying 2% – and your employer is paying 13.8% – in National Insurance.
At least until March 2029, however, you can sidestep National Insurance on earnings diverted into a salary sacrifice pension. Your employer might even be generous and share some of its 13.8% savings with you, too.
The point is, you can lose a lot in tax for each extra £1 that you earn.
Good things come to those who wait
Let’s set up a good old personal finance example scenario.
Meet Ingrid and Hans – a high-earning couple with children.
Ingrid earns £80,000 after matching pension contributions. Ingrid pays a marginal tax rate of 57% due to the HICBC the couple pay for their three children.
Her husband Hans earns £70,000 after matching pension contributions. His marginal tax rate is 40%.
They’ve borrowed £750,000 as a mortgage to buy their family home. Assuming a 5% rate over 35 years, they are paying £3,787 per month in repayments.
Ingrid and Hans are quite frugal elsewhere in their lives. They project that they’ll be able to put aside £40,000 this year.
What should they do with this surplus cash?
Making mortgage overpayments
Hans’s first instinct is to use the £40,000 to make an overpayment on their mortgage. That’s well within their 10% annual mortgage overpayment allowance.
After tax – and after handing over £40,000 to the mortgage lender – they’re left with £68,122 in spending money:
| Pre-tax income | Net income | Mortgage over-payment | Net income remaining | |
| Ingrid | £80,000 | £56,961 | £20,000 | £36,961 |
| Hans | £70,000 | £51,161 | £20,000 | £31,161 |
| Total | £150,000 | £108,122 | £40,000 | £68,122 |
Making extra pension contributions
What if they instead put £40,000 into their pensions via salary sacrifice?
Now they’re left with £88,150:
| Pre-tax income | Net income | Child benefit | Net income remaining | |
| Ingrid | £60,000 | £45,361 | £3,268 | £48,629 |
| Hans | £50,000 | £39,521 | £0 | £39,521 |
| Total | £110,000 | £84,882 | £3,268 | £88,150 |
In each scenario they’ve effectively invested £40,000, just in different ways:
- In the first scenario, the £40,000 went towards mortgage overpayments. (Remember, paying off a mortgage is a form of saving [5].)
- In the second, the money went towards pension contributions.
Due to the tax savings however, with the second strategy they also have around £20,000 more in their bank accounts.
This makes sense when you consider that they have a marginal tax rate of around 50% between them.
Later taxes paid on pension withdrawals have an impact
Before you run down to your pension provider’s office to start stuffing banknotes through the letter box, I should acknowledge it’s not all quite so simple.
This is mostly because pensions don’t completely avoid tax. Rather, they delay it and potentially reduce the rate you pay.
So yes, Ingrid and Hans now have an extra £40,000 in their pensions.
But even when they turn 55, 57, 58 or whatever the legal age of access might be at that point, they can’t just withdraw the entire pot unscathed.
Rather, at that point they must pay tax on the money they take out.
The first 25% of pension cash can be taken out tax-free (up to £268,275) thanks to the tax-free lump sum. [6]
But on withdrawals beyond that, they’ll pay income tax at their prevailing rates.
Paying down the mortgage from a pension
Let’s imagine a slightly different scenario.
Assume Ingrid and Hans have been working on their plan for many years. They are now turning 57, and the time has come to reap the benefits.
For the last two decades, the couple had an interest-only mortgage. That meant their monthly mortgage payments were lower – simply covering the mortgage interest.
On the plus side this meant they could direct the spare cash into pensions and ISAs. As high-earners who saved hard and invested well, they each amassed seven-figure pension pots.
The downside is they still owe the full £750,000 on their mortgage.
Step 1: the lump sum
At 57, both Ingrid and Hans have access to their pension balances for drawdown. Their pensions qualify for the maximum £268,275 tax-free lump sums, which they both take.
This totals to £536,550, which they send to their mortgage lender, immediately reducing their outstanding mortgage to £213,450.
The monthly interest due drops to £890.
Step 2 – the pension drawdown
They decide to pay the remaining mortgage down over ten years. This way it will be paid off entirely by the time they are 67.
This means they’ll need to withdraw £9,605 in the first year for the interest payments and another £21,350 each year to pay down the outstanding balance:
| Over-payments | Balance | Interest due | Total payment | |
| Opening Balance | £750,000 | |||
| Lump Sum | £536,550 | £213,450 | ||
| Year 1 | £21,350 | £192,100 | £9,605 | £30,955 |
| Year 2 | £21,350 | £170,750 | £8,538 | £29,888 |
| Year 3 | £21,350 | £149,400 | £7,470 | £28,820 |
| Year 4 | £21,350 | £128,050 | £6,403 | £27,753 |
| Year 5 | £21,350 | £106,700 | £5,335 | £26,685 |
| Year 6 | £21,350 | £85,350 | £4,268 | £25,618 |
| Year 7 | £21,350 | £64,000 | £3,200 | £24,550 |
| Year 8 | £21,350 | £42,650 | £2,133 | £23,483 |
| Year 9 | £21,350 | £21,300 | £1,065 | £22,415 |
| Year 10 | £21,300 | 0 | 0 | £21,300 |
The first year is the toughest. They need to find almost £31,000 from their pensions. They’ll presumably have living expenses as well.
But things do get easier as their outstanding mortgage balance falls and the interest payments come down with it.
Even pensioners can be liable for tax
Unfortunately, with their tax-free pension allowances totally used up, HMRC now wants a cut of this couple’s pensions withdrawals.
However the way income tax is structured, this isn’t as painful as you might think.
The 40% band doesn’t kick in until at least one of them is withdrawing more than £50,271 from their pension. Splitting the withdrawals and mortgage payments between them means they almost certainly won’t need to pay 40% tax on any of their income.
If together they withdraw £30,000 for living costs and £31,000 to cover the mortgage and overpayments in year one, then individually they’ll be drawing down £30,500 from their pensions.
And after their personal allowances [2] for income tax, they will each pay only around £3,600 in taxes – or approximately 12% of the money they withdraw.
The difference between tax rates is key
This example neatly illustrates why paying off your mortgage with a pension can work so well.
When this money was first directed into their pensions, they deferred paying roughly 50% in income tax.
Then, when it came time to draw it out, the lump sum incurred no tax at all, and the remaining withdrawals only cost them around 12%.
What’s more, in terms of the total money used to pay down the mortgage balance, more than 90% of this cash – pre-tax – went towards doing so.
That’s a huge difference compared to paying it down earlier in their lives, when up to 57% would have gone to HMRC before the overpayments even landed with their lender.
Risks are everywhere
Of course nothing is totally risk free [7], and this strategy has plenty.
A big one is that it is dependent on the current tax rules as they stand.
But the rules around the tax-free lump sum have already changed a few times. And the treatment of National Insurance for salary sacrifice pensions will alter in April 2029.
The minimum pension age could be moved up again from 57, too, delaying when you can withdraw your lump sum.
The point is there’s no guarantee that this method will still exist in the same shape by the time you come to retire.
Another issue is that interest-only mortgages are perfect for this scenario, but if they are structured in a way that at the end of the term you either pay off the full balance or you have to sell the house, then tax changes might force you into an unwanted sale.
Getting a mortgage that lasts into your 60s or even 70s can mitigate that, because you’ve got more time to come up with a plan. But that isn’t bulletproof.
Also, interest-only mortgages [8] themselves aren’t so widely available these days.
Finally, investment returns in your pension are by no means guaranteed. If you invest the money in the stock market, then it’s possible that even over a couple of decades your returns could be lacklustre.
By contrast, paying down a mortgage delivers an immediate and certain return.
Summary of mortgage overpayments versus using your pension
| Mortgage overpayments | Pension repayments | |
| Tax efficiency | None. Paid out of net income that has already been taxed up to 57%. | High. Contributions reduce gross income, unlocking Child Benefit and avoiding 40%+ tax. |
| Liquidity and control | Locked in bricks & mortar. Hard to get back unless you equity release or downsize. | Locked in pension. Unaccessible until age 57, but highly liquid and investable once inside. |
| Growth potential | Overpayments return a guaranteed 5% (by avoiding mortgage interest). | Pension investments can compound in global equities, potentially beating 5% over 20 years. |
| The end game | Mortgage steadily drops to £0 over 25–30 years. | Mortgage remains flat, then gets potentially wiped out in one go with tax-free cash at 57. |
The bright side
Of course you don’t have to push quite so hard as Ingrid and Hans.
For starters, not everyone can amass over £1,000,000 in a pension to max out the tax-free lump sum withdrawal.
You might instead choose to stick with a repayment mortgage, but decide that you’ll shovel spare cash into your SIPP rather than make mortgage overpayments.
And when you reach retirement age, if you can then pay off the balance with a tax-free lump sum then, well, congratulations!
But if not – perhaps because the tax-free lump sum has been done away with, you’ll just crack on – and withdraw money from the pension at 20% tax.
It’s not as good as you’d hoped for. But if you saved 50% tax on the way in then you’re still doing well.
It’s not for everybody
Some people love the freedom that a fully paid-off mortgage gives them.
No arguments from me there.
But if you’re already planning to invest heavily to build up a healthy ISA and pension balance, then it might be worth cracking out a spreadsheet.
- The Investor wrote an article on paying down your mortgage or investin [9]g. It doesn’t explicitly take taxes into account. But it’s a good place to start on the risks and the potential rewards, and there’s a spreadsheet you can duplicate for your own use.
For us, since we view our next home as a temporary venture, the pieces slot into place more neatly.
We’d be quite comfortable with needing to sell up in our fifties. If downsizing and utilising our pension lump sums lets us become mortgage-free, then that’s perfect.
Equally, if our lump sums let us take a huge bite out of the mortgage, and we can easily afford the monthly payments for a few more years whilst we decide where to move to, that’s also fine.
What if the government has eliminated the tax-free lump sum or increased tax rates on pension withdrawals by then?
Well, then we won’t benefit as much as we had originally hoped. But investing is all about taking calculated risks.
The point is that I’ll be prioritising my ISAs and SIPPs ahead of making mortgage overpayments over the next few years.
And I’ll be crossing a few fingers for a couple of decades!