Mortgage or pension? Where to put your spare cash

If you've managed to salt away some cash during this never-ending lockdown, you might be wondering what to do with it. With banks potentially soon charging you to hold this money, you might want to put it to work. Two of the most common approaches to use excess cash are to pay down your mortgage or ramp up your pension.

But which is the best option?

The plan

While it’s easy enough to ring up your bank and instruct them to start overpaying your mortgage – depending on the terms of your contract – financial advisers will typically advise you to give it some consideration first.

This is because whether the money is going on your mortgage or into your pension, both approaches mean your money is effectively taken out of your hands for a long period of time.

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"The first thing I'd say is to make sure you have a cash reserve, or rainy day fund," says John Tuohy, financial adviser and chief executive of Acuvest. And, depending on your needs, he suggests this should be enough to cover spending for as much as a year.

This should be kept on deposit – regardless of the poor returns on offer.

“We’ve been spoilt in the last 30 years because they [deposits] paid us so well,” he says, adding that while they don’t offer returns now, they still offer security.

Paul Merriman, financial adviser with Askpaul.ie, agrees that getting a rainy day fund in place should be a priority, followed by a review of what your short-term financial needs might be in the next few years, before you take the plunge.

“You don’t want to put money off your mortgage and then have to go back and borrow for a car two or thee years later at 6 per cent,” he says.

If possible, it’s also worth taking some time to consider your financial priorities before effecting that direct debit; how old will you be before your mortgage is paid off? How well funded is your pension?

And if you’re on a cheap tracker rate, such as ECB+ 0.5 per cent, it will make even less sense to overpay your mortgage – at least from a financial perspective – as your cost of funds is so low.

The finances

Once you have a view of your overall financial outlook, you can then consider specific options. So which offers the best return?

Let’s look at it from a purely financial perspective first.

If you have a mortgage of €300,000, with a term of 30 years and an interest rate of 2.5 per cent, monthly repayments will be €1,185.36. Ten years into the term, you pay off an extra €10,000. So what’s the impact?

Well, first of all, you’d finish paying off your mortgage 13 months earlier (which would have cost you €15,405 otherwise, interest rates staying the same). More significantly, however, you’ll also knock about €15,000 off your total interest bill. So a €10,000 overpayment definitely offers significant rewards; you’ll save about €5,000 in repayments, and a further €15,000 in interest, as well as finishing with it sooner.

To look at it another way, you could consider putting what you’re saving on your monthly commute towards your mortgage. Overpaying on a regular basis also has significant benefits.

Consider an overpayment of €200 a month on the same mortgage. If applied at the start of the mortgage term, it would cut about six years off the term of the mortgage, and save you about €36,000 in interest payments.

Most lenders will allow you overpay your mortgage by a certain amount even on a fixed rate; if you’re on a variable or tracker, you can typically overpay by as much as you want.

The second option is to bump up your pension fund. The big appeal of putting extra money into your pension is the tax benefits which accrue.

A €10,000 lump sum will attract tax relief of 20 per cent for those on the standard rate, or 40 per cent for those on the higher rate, provided that you haven’t hit the age-related tax relief limits. So, this €10,000 could turn into an investment of €12,500 for standard rate taxpayers, or €16,666 for those on the higher rate. Straight away you’ve achieved a 20 or 40 per cent return then.

And if you have 20 years to retirement, and achieve an average annual return of 5 per cent, your money for a higher rate taxpayer will have grown to about €44,000 by this date (of course it could be more or less depending on investment performance during the period).

That is significantly more than the amount saved by paying down your mortgage. And if you opt for an approved retirement fund when you retire, whereby your money will stay invested, this €10,000 could still be offering you a return when you’re 90.

Another advantage of opting for your pension is that if you’re not already making your maximum contributions, upping your monthly contribution may also mean that your employer also increases theirs. So you win again on this front.

Consider that €200 extra a month you were thinking of putting against your mortgage. For a higher rate taxpayer, this would translate to a monthly investment in a pension of €280 thanks to tax relief in a pension. Over 30 years thanks to compound interest, this would be worth more than €136,000 based on an annual return of 2 per cent, or €220,000 with an annual return of 5 per cent.

Looking at it from the maths side then, it’s clear that the biggest bang for your money can come from investing in a pension.

“It will work 10 times harder for you in a pension plan than in the mortgage,” says Merriman.

The decision

But just because a pension investment has the potential for a greater financial reward doesn’t mean it’s the right one for you.

“The optimal financial decision might not be the best thing for people to do,” says Tuohy, adding: “It’s also about the quality of life aspects; certainly you have people where the idea of reducing their mortgage gives greater peace of mind.”

In this respect then, “there is no bad decision; they’re both valid”, he says.

Merriman agrees that paying down a mortgage is important emotionally, and is a sign of success for some. “It is a great achievement to be mortgage free at 50-55 years of age,” he says, because of the peace of mind it can offer.

“A lot of couples in their 40s may have bought in 2006-07, and their mortgage has been an awful mental struggle and they can’t wait to get rid of it.”

The guaranteed nature of paying down your mortgage is also an advantage to some. Reducing your debt is an absolute; with a pension, given charges and investment volatility etc, what goes in doesn’t always come out as might have been expected.

Another consideration is the length of time to retirement, and how long you’re locking your money away for. “A pension definitely wins out over everything – but you are giving up that access,” says Merriman.

Money into a pension is effectively gone (unless converted into a buyout bond when it might become accessible from the age of 50). While money paid into a mortgage may be gone too, nonetheless it offers some element of flexibility. A bank may be open to lengthening the term for example, which would reduce monthly repayments, should you get into financial difficulties down the road.

Another advantage is that by paying it down, you may be able to refinance at a lower rate – Avant, for example, offers its market-beating rate of 1.95 per cent to those with a loan to value of 60 per cent or below.

Mortgage rates are also important: if they were to rise, it may make more financial sense to pay down a mortgage.

In any case, if you have extra money, it’s not necessarily a choice of one over the other; as Tuohy notes, you can cover yourself and “do a bit of both”.