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Should you use your pension lump sum to pay off your mortgage?

Essential key considerations and potential pitfalls you need to know

With interest rates much higher than they’ve been for many years, using your pension tax-free lump sum to pay off your mortgage might initially seem prudent. Reducing your monthly outgoings can be appealing, particularly if you’re approaching retirement and looking to streamline your financial commitments.

This move could potentially free up more disposable income, allowing you to enjoy your retirement with fewer financial burdens. Additionally, the emotional comfort of owning your home outright and eliminating mortgage debt can provide significant peace of mind, making this option worth considering.

Fraught with potential pitfalls

However, paying off your mortgage early using your pension lump sum is fraught with potential pitfalls that require much greater evaluation. While the immediate financial relief is tempting, there are complex tax implications and long-term financial consequences to consider. For instance, withdrawing more than the tax-free portion of your pension can result in hefty tax liabilities, which might negate the benefits of reduced mortgage payments.

Moreover, depleting your pension fund early could compromise your retirement income, potentially affecting your quality of life in the future. Given these nuances, assessing your unique circumstances and seeking professional financial advice is essential to determine the best course of action.

Here are some key points to ponder as you navigate this significant financial decision.

Tax implications

You can access most workplace and personal pensions from age 55 (or 57 from April 2028) and use the money as you wish. However, while you can withdraw the first 25% as a tax-free lump sum (capped at £268,275 for most people), any additional withdrawals will be taxed at your marginal Income Tax rate.

If your 25% tax-free lump sum doesn’t cover your outstanding mortgage, making a taxable withdrawal to pay it off in full probably won’t make financial sense as it would trigger a range of additional tax considerations. It’s imperative to weigh the tax implications carefully before making any decisions.

Interest rates and mortgage payments

When interest rates are low, you’re probably better off leaving your money in your pension. This is because the potential growth rate in your pension is likely to be higher than your mortgage interest rate. There are some instances where paying off your mortgage might be the better option, so make sure you seek advice on what’s right for you.

When interest rates are high, it isn’t quite as straightforward. It may still be the case that your pension fund has the potential to grow at a greater rate and benefit you more in the long run than paying off your mortgage early would. It’s also worth remembering that most lenders only let you overpay your mortgage by 10% yearly.

Early redemption repayment charges

If you go over this amount while in a fixed rate deal, you might have to pay an early repayment charge (ERC) of between 1% and 5% of the outstanding balance. Before making any overpayments, make sure you check when your deal is due to end. Planning ahead can help you avoid these potential penalties.

Impact on retirement income

Taking money out of your pension to pay off your mortgage could have longer-term repercussions. A smaller pension pot will generate less income in retirement, which means you might be unable to afford the lifestyle you were hoping for or, worse, run out of money. This could far outweigh the short-term benefit of having lower monthly outgoings for a few extra years.

By using cashflow modelling, we can demonstrate how long your money will last in retirement and the impact that paying off your mortgage early would have on this. Withdrawing money from your pension could be especially detrimental during a stock market downturn.

Market fluctuations

If you sell investments that have fallen in value, you could deplete your pension pot more quickly than you anticipated. By leaving the money invested, your pension will have the opportunity to recover from dips in stock market performance and hopefully go on to produce a healthy and sustainable retirement income over the long term.

Exploring other options

If you do want to pay off your mortgage, there are other ways to fund this other than via your pension. Individual Savings Accounts (ISAs), for example, let you withdraw as much money as you wish tax-efficiently. ISAs also form part of your estate for Inheritance Tax purposes, whereas pensions typically do not.

Depleting ISAs before pensions could make sense if you want to leave a tax-efficient financial legacy for your loved ones. In a stock market downturn, however, withdrawing money from cash ISAs and savings accounts could be a better option, as you’ll leave your investments untouched and give them the chance to recover in value.

THIS ARTICLE DOES NOT CONSTITUTE TAX OR LEGAL ADVICE AND SHOULD NOT BE RELIED UPON AS SUCH. TAX TREATMENT DEPENDS ON THE INDIVIDUAL CIRCUMSTANCES OF EACH CLIENT AND MAY BE SUBJECT TO CHANGE IN THE FUTURE. FOR GUIDANCE, SEEK PROFESSIONAL ADVICE.


Adam Reeves

Author: Adam Reeves

DipPFS Cert CII (MP&ER)
Independent Financial Planner, Wealth Manager, Director

Last updated on

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Adam was quick to assess & understand my situation, and was able to discuss & communicate in a very concise and simple way the various options available to me, taking time for me to understand and clarify where necessary. My understanding & knowledge of taxation & pensions has increased significantly allowing me to feel much happier making financial decisions for the future.

Rob – West Sussex

Adam and his team undertook in-depth research into our existing QROPS schemes and clearly set out both pros and cons of transferring the funds back to the UK. Having decided to go ahead with the transfer, Adam and his team worked extremely hard to facilitate the transfer. The QROPS pension trustees were not always the most professional or responsive organisation – however we were very grateful for the perseverance and commitment that Adam showed us as clients.

Jonathan – East Sussex

Adam offered a range of financial products , the one he suggested was affordable and proved to be a good choice.  Returns on investments have exceeded my expectations, based on Adam’s advice and guidance. Profits have enabled house improvements to take place.

David - Surrey

Adam arranged an appointment very timely, he explained his role and qualifications as an IFA giving me reassurance , we went through my retirement and investment goals. Adam discussed my options explaining in great detail, I felt relaxed during our discussions allowing me to fully understand my choices. I feel very confident in the financial advice allowing me to enjoy my retirement.

I was very happy with Adam’s recommendations and explanations of financial products which would suit my retirement goals, I feel this has helped me review and reduce my financial risk as I reach retirement, leaving me feeling confident that I can enjoy my retirement plans.

Ron – West Sussex

After initial meeting Adam put together a very detailed and thorough written plan. At our second meeting he went through the whole booklet and explained everything in layman’s terms which made it a lot easier to understand.

I am very happy with everything that was suggested and put in place especially with something as big and important as pensions. Adam and his team have taken a huge weight off my shoulders and I would highly recommend their services to anyone needing help with their financial planning and pension.  Adam couldn’t have been more helpful, and even came outside his normal area to meet me on a number of occasions.

Richard - Kent

Unfortunately I had to claim on my critical illness insurance due to my wife being ill and because of the sound advice Adam gave in acquiring this insurance we ended up being financially safe through a tough time.

Steve - Kent

Adam did a review of our financial situation, confirmed that Flexible Drawdown best suited our needs as a family, and then did all the research into the best product for us. He will continue to monitor it for me. He acted extremely promptly because we had a deadline for requiring the lump sum; went out of his way arranging meetings during non-office hours, was professional yet friendly and explained a difficult subject very well.

Clare – East Sussex

Adam did a thorough review of my pension policies, clearly explained how well they had performed, how flexible they were, how the market regulation has changed, and, crucially, what the tax implications would be if I were to leave them untouched. He accurately assessed my attitude to risk and recommended an up-to-date solution that will offer me the greatest flexibility at retirement.

Greg – East Sussex
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