What should these lucky winners do with their monthly windfall? Overpay their mortgage or save in their pension?
Take someone with a 20-year £200,000 repayment mortgage and an interest rate of just 1 per cent. Their normal monthly repayment would be £919.79. Overpaying by £300 a month – by increasing their payment to £1,219.79 – would have the effect of reducing their mortgage term to 14 years eight months.
The total amount repaid would fall from £220,749.27 to £215,141.07, a saving of just £5,608.20. This is not surprising and we can predict that at a rate of 0 per cent, they would make no saving at all (other than the time value of the last five years’ payments), since all they are repaying is the principal.
But by paying £300 a month net into their Sipp, a basic-rate taxpayer would have amassed a pension fund of £82,517 after 14 years and eight months. This is based on an expected net annual return of only 3 per cent – less than the yield on 15-year government gilts which have a current redemption yield of 3.65 per cent.
The tax-free lump sum alone (£20,629 – one-quarter of the fund) is almost three times the saving made by overpaying the mortgage. Again, this should not be a surprise. Tax relief has the effect of boosting the rate of return – in this example, from 3 per cent to 5.9 per cent.
So the question arises, why repay a loan charged at 1 per cent when a 5.9 per cent return on the same money is realistically attainable? A higher-rate taxpayer would do even better, amassing a fund of £110,023 based on annualised growth of 3 per cent net of charges. If their pension investment returned 6 per cent a year after charges, they could look forward to a fund of £138,721.
Even those paying higher rates of interest would be better off saving in their pension. Someone on a typical standard variable rate of 4 per cent would see their 20-year mortgage term fall to 14 years seven months by overpaying £300 a month. Their monthly payments increase from £1211.96 to £1511.96. Total repayments over the term would fall from £290,870.56 to £264,190.92, giving a total saving of £26,679.
However, a basic-rate taxpayer saving £300 a month net of tax relief would build a pension fund of £81,940 over 14 years seven months (at a return of 3 per cent a year). A higher-rate taxpayer would build a fund of £137,551 at the same rate of return.
In topsy-turvy markets, some remarkable opportunities arise. This one should help to persuade the average borrower that saving in their pension is a better bet (at least in the short term) than boosting their mortgage payments. On my calculations, anyone paying less than 7 per cent mortgage interest rate should seriously consider the pension option.
John Lawson is head of pensions policy at Standard Life