Important information - investment values and income from investments can go down as well as up, so you may get back less than you invest.
Using pension tax-free cash to pay off your mortgage can be an appealing way to become debt-free. But is it always the best financial move?
We looked at how the sums can stack up – and why what you do with the money you save on mortgage repayments can make a big difference.
What is pension tax-free cash?
You can usually take up to 25% of your pension savings as a tax-free lump sum, subject to a maximum of £268,275 for most people. You can normally start accessing this money from age 55, although this is due to rise to 57 from April 2028.
As our modelling found, taking tax-free cash and using it to pay off a mortgage could leave someone between £122,000 and £7,000 worse off than if they’d left it invested in their pension, depending on what they do with the money.
Of course, each person’s situation will be unique and you’ll need to weigh up your personal circumstances to work out what’s best for you.
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Our scenario
-
Person A and Person B are both aged 55.
- They both have £75,000 left to repay on their mortgage over the next 10 years.
- They both have an interest rate of 4% and monthly repayments of £759.
- We assume the mortgage rate remains at 4% for the full 10 years and there are no early-repayment charges.
- They both have a pension worth £300,000 currently and can take up to 25% of that as tax-free cash.
- Neither needs to take an income from their pension until age 65, and for simplicity we haven’t factored in any additional pension contributions.
Person A decides to take all the tax-free cash (£75,000) at 55 and use it to clear their mortgage debt. This leaves them with £225,000 in their pension.
Person B leaves their tax-free cash invested and continues to repay their mortgage as per the repayment schedule until age 65.
Watch: Mortgage, ISA or pension? What most people get wrong
The outcomes
By clearing their debt early rather than continuing repayments to the age of 65, Person A saves around £16,100 in interest.
The investments in their pension grow in value by an average of 5% a year after fees, so by age 65 Person A’s pension is worth approximately £366,500.
Person B doesn’t take their tax-free cash at 55. They leave their £300,000 pension invested and, by age 65, it has grown in value to approximately £488,700.
Because the value of their pension has grown, the value of their 25% tax-free cash has also increased.
Person B could potentially take around £122,200 tax-free at 65, subject to their available lump sum allowance and the pension rules applying at that point. This is around £47,200 more tax-free cash than Person A took at 55.
Who is better off?
Person B has around £122,200 more in their pension by age 65. What’s more, by leaving their pension invested, Person B may also be able to take more of the money tax-free.
However, that isn't a like-for-like measure of how much better off they are. Person B has had to continue making £759 monthly mortgage payments for 10 years. By contrast, Person A has had an extra £759 a month (£9,108 a year) available to spend or save.
What if Person A invested their savings?
When your disposable income increases, it can be very tempting to simply spend that extra money.
However, if rather than spending that money, Person A invested their £9,108 per year into a stocks and shares ISA instead, there would be a much smaller difference in outcome.
By age 65, Person A would have:
- Pension: ~£366,500
- ISA from investing £9,108/year: ~£114,600
- Total financial assets: ~£481,100
And Person B would have:
- Pension: ~£488,700
- ISA: £0
- Total financial assets: ~£488,700
In this scenario, Person B would still have more money overall – around £7,600 more in total assets – but the difference is much smaller than if Person A simply spent the extra money.
We assume the ISA contributions are made at the end of each year.
- More on the Fidelity Stocks and Shares ISA
The balance between investment returns and mortgage rates
These figures come from one specific scenario, and the outcome won't be the same for everyone.
For example, in our scenario, if investment returns were 7% per year rather than 5%, then Person B could end up even better off.
Assuming they invested their mortgage savings into an ISA, Person A could end up with total financial assets of around £568,400 compared with around £590,100 for Person B. With the higher investment return, the difference between the two increases from around £7,600 to almost £22,000.
But if investment returns were lower relative to the mortgage rate, this could tilt the balance in favour of taking the tax-free cash and using it to pay off the mortgage. In our scenario, if investment returns were 3% per year, then Person A would end up with around £3,600 more than Person B.
Similarly, if mortgage rates were higher, this would make overpaying the mortgage look more attractive.
Other considerations
It’s also important to highlight the tax considerations. Person B could potentially take more tax-free cash by leaving the money invested. However, Person A has the benefit that, by age 65, a large chunk of their financial assets are in an ISA and withdrawals from ISAs would normally be tax-free. This assumes they invest their mortgage savings in an ISA.
By contrast, withdrawals from a pension above any available tax-free amount may be subject to income tax.
There can also be a huge psychological benefit to clearing your mortgage. Paying off the debt gives you a guaranteed saving on future interest, whereas investment returns are uncertain. And if becoming mortgage-free significantly reduces your expenditure in retirement, that could mean you need less pension income in the first place.
But tax-free doesn’t mean consequence-free. Money taken out of your pension to repay the mortgage is money that’s no longer invested to potentially grow and provide an income later in retirement.
It’s also important to check your mortgage terms before doing anything. Would you face an early repayment charge or restrictions on overpayments?
Ultimately, everyone’s situation will be unique. You need to consider what both options mean for your retirement as a whole. Ask yourself: how much retirement income might I be giving up by taking this money out of my pension, and how much will becoming mortgage-free reduce the income I need?
Finally, think about how much cash you need available. Using pension cash to pay down your mortgage moves wealth from being relatively accessible to being tied up in your home. If you subsequently need that money to meet unexpected costs or support your lifestyle in retirement, getting it back out of your property may be much more difficult.
If you’re finding the decision particularly tricky, it could well be worth speaking to a financial adviser to get a clearer sense of your options.
Got a burning question you want to ask? Why not drop us a line. Click here to ask your question.
Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Tax treatment depends on individual circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). This information is not a personal recommendation for any particular investment. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.
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