If you have a six-figure salary, then the idea of overpaying your mortgage can be appealing. Paying off your mortgage sooner could save you a lot of money, and is the right decision in some cases.
But there’s one main question you should be considering before you make a decision on your mortgage — are you contributing to your pension? In fact, with some clever pension planning, you could pay your mortgage off twice as fast than you would with overpayments.
Read on to discover how.
How much do you need to overpay your mortgage?
If you’re contemplating making mortgage overpayments, you first need to calculate how much income it will require. You can use an online overpayment calculator to help you with this calculation, as well as other online resources to help understand the numbers, such as the financial planning journal at saltus.co.uk.
But let us explain one example further, considering a mortgage of £250,000.
The higher earner in question wants to make overpayments of £1,000 each month (£12,000 a year) and their salary is exactly £129,358.62.
If we take £29,358.62 of the individual’s income:
- The normal rate of National Insurance will cost £587.17
- The Income Tax rate of 40% will cost £11,743.45
- The loss of Personal Allowance and additional income tax at an effective rate of 60% will cost £5,028
In order to make the total payment of £12,000 per year, it will require almost £30,000 in income and cost £17,358.62 in taxes. Paying off £250,000 of your mortgage will require more than £600,000 of income and take almost 21 years.
It is worth noting this example doesn’t account for any charges that your mortgage provider may also apply for overpaying your mortgage.
The 60% tax trap
When evaluating the income needed to overpay your mortgage, it is important to remember the dreaded 60% tax trap. As per the example above, an income in excess of £100,000 is not only liable to a higher tax rate of 40%, but is also impacted by a reduced tax-free personal allowance.
When you reach an income of £100,000, your personal allowance is cut by £1 for every £2 of additional income. You lose your personal allowance completely when your income reaches £125,140.
You’ll need to take this tax system quirk into account, when calculating how much income you need to pay off your mortgage, and how much tax you may end up paying.
Make use of your pension contributions
By using your pension instead of overpayments, you could pay off your mortgage quicker. Taking the same figure in the example above, contributing £29,358.62 to your pension will be gross of all tax. Not only does this mean you will not be liable for £12,330.62 in standard income tax and NI, but also can avoid the 60% tax trap saving a further £5,028 in income tax.
In addition, when you’re able to access your pension, you can take 25% of it completely tax-free. Depending on the size of your pension pot, you could take this portion free of tax — a maximum of £268,275 — which would be more than enough to pay off a £250,000 mortgage in full.
If you made regular pension payments and then accessed your tax-free cash to pay down the mortgage, you could save over £360,000 in tax, and pay off your £250,000 mortgage in just over eight and half years — 13 years faster than making overpayments!
If you’re a high earner and exploring your mortgage options, then it’s important to consider seeking pension advice from an expert financial planner. You could potentially save yourself a significant sum and pay off your mortgage quicker.
Disclaimer: Information is correct to the best of our understanding as at the date of publication. Nothing within this content is intended as, or can be relied upon, as financial advice. Capital is at risk. You may get back less than you invested.