Key Post Compounding doesn't just work on pensions - it also works on mortgage overpayments!

Time and time again, posters will trot out the statement "the earlier you start your pension, the longer you have for the power of compounding to work".

But this is only half the story. Compounding also works on mortgage overpayments in the same way.

If you make an AVC of €1,000 to your pension today, and you get a return of 3% a year, it will be worth €1,806.11 in twenty years.

But it's the exact same for a mortgage overpayment. If you make an overpayment of €1,000 today, and keep the rest of your repayments the same, your mortgage balance will be lower by €1,806.11 after 20 years.

Pensions are a great tax-efficient way to save for the future and nothing in this post says otherwise.

But sometimes other priorities are higher. If you have a big mortgage relative to either your salary or the value of your home, paying down the mortgage to a comfortable level should take priority.

If you overpay your mortgage now, you will have more scope to maximise your pension contributions later.

But the key point to understand is that compounding works on both overpaying your mortgage and contributing more to your pension scheme.

The advantage of contributing to a pension over making a mortgage payment is the fact that the pension fund compounds tax-free. This is very important and all other things being equal, this would favour allocating more of your savings to your pension than to overpaying your mortgage.

But all other things are not equal.

Overpaying a large mortgage has huge benefits

1) The compounding effect which I have already mentioned is very important.
2) The return on overpaying your mortgage is risk-free and tax-free and charges-free. If you have a fixed rate of 3% on your mortgage, you are getting a tax-free, risk-free and charges-free return of 3% on your "investment". With a pension, you face the risk of poor investment returns and high charges. Of course, the return from your pension fund after charges could be higher than the mortgage rate.
3) You are more protected against big rises in interest rates.
3 1/2) A lower Loan to Value usually results in a lower mortgage rate on your entire mortgage
Getting a mortgage down to 60% or 50% of the value of your home usually means that you can avail of the lowest rates on the mortgage.
4) It will be easier to trade up. If you expect to trade up in the next few years, having a fat pension fund won't be much use to you. But having a much smaller mortgage will be a great help.
5) If you suffer an income drop through unemployment, it will be much easier to find a sustainable restructuring to a lower LTV mortgage than a higher LTV mortgage.
6) If you wish to take extended unpaid maternity leave or a career break or if you want to reduce your working hours, it will be much more affordable if you have a smaller mortgage.
7) If a couple splits up, there will be huge immediate financial pressure and a smaller mortgage will be a big advantage.

At the end of the day it's a question of balance

On the one extreme, if you have very little in your pension fund, a comfortable mortgage, secure job, less than 20 years to retirement and have no plans to trade up, prioritise your pension.

On the other extreme, if you are in your mid 30s, already contributing to a pension fund, with a big mortgage which requires both of you to work to service it, then prioritise paying down the mortgage to a comfortable level over making AVCs.

There is a very good case study here where it's clear to me that they should reduce their mortgage to a much more comfortable level.



Brendan

Hi Brendan,

It would be interesting to see what the long-term net of fees return from pensions are versus the effective guaranteed saving from mortgage payments.

Also, excuse me, but I'm very fuzzy on the tax relief available on mortgage repayments so just a question - is it fair to describe the interest saved as tax free if the reduced interest payments have the impact of reducing mortgage related tax relief?

jasdpace@gmail. said:

Also, excuse me, but I'm very fuzzy on the tax relief available on mortgage repayments so just a question - is it fair to describe the interest saved as tax free if the reduced interest payments have the impact of reducing mortgage related tax relief?

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AFAIK there is no explicit tax relief on owner-occupier mortgages any more.

However paying down your mortgage sooner is equivalent to a tax free investment because: (1) you don't pay tax on the notional rent you pay yourself for living in your own house; (2) capital gains on your PPR are free of CGT.

NoRegretsCoyote said:

However paying down your mortgage sooner is equivalent to a tax free investment

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Not really. That is a justification for saying that buying a house is a tax-free investment. I don't think that paying the mortgage off quicker affects that?

However, paying down your mortgage sooner is tax-free compared to, for example, putting money on deposit.

Let's say you get 3% deposit interest, you would pay 40% DIRT on it, and so the net return would be only 2%. Whereas saving 3% mortgage interest by paying down your mortgage, earns you the full 3% - "tax-free".

Brendan

Great post Brendan, very interesting, agree its a balancing act. On the whole, i agree, as changing debt levels to “comfortable” levels give more choices.

Personally, i did more or less what you have described, i focussed on the 25 year trade up mortgage, i took out aged 30,
(while Paying in standard 4% into DC) got mortgage to LTV 50% by 40, by switching a number of times, getting lower rates each time, as mortgage interest reduced as the LTV reduced, and increasing payments each time i switched,(+ house prices rose) knocking off almost 5 years, and at that stage, i switched to start maxing out AVC’s. Mortgage cleared by 50. We had one year left to go, and just paid it off, as we were already maxing out Pension/AVC, by then.

Brendan Burgess said:

The advantage of contributing to a pension over making a mortgage payment is the fact that the pension fund compounds tax-free. This is very important and all other things being equal, this would favour allocating more of your savings to your pension than to overpaying your mortgage.

But all other things are not equal.

Overpaying a large mortgage has huge benefits

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Not disagreeing with your post/view. You have presented a simplistic view of the choices.

I do think that your premise needs slight adjustment.

You have articulated that Option A = Option B, but B also has all these other benefits.

The spectrum is actually Option A + 20/40% of Option B or Option B.

Option A is the €1000 AVC contribution but you also get €200/400 to contribute to your mortgage overpayment.

You have ignored the tax relief.

Brendan Burgess said:

But this is only half the story. Compounding also works on mortgage overpayments in the same way.

If you make an AVC of €1,000 to your pension today, and you get a return of 3% a year, it will be worth €1,806.11 in twenty years.

But it's the exact same for a mortgage overpayment. If you make an overpayment of €1,000 today, and keep the rest of your repayments the same, your mortgage balance will be lower by €1,806.11 after 20 years.

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Its more accurate to reflect that you could have: 120/140% of your money compounding vs. 100% of your money (with the ancillary benefits accruing faster but with opportunity cost).

Whilst this point is theoretically correct doesn't the fact AVCs benefit from a tax break make it irrelevant in practice?

A 1,000 AVC is equivalent to 800 or 600 paid of a mortgage. So the starting point for compounding will always be different because of the tax break.


I'd always say there's room for doing both and it doesn't have to be A or B

Itchy said:

You have ignored the tax relief.

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I haven't.

Brendan Burgess said:

The advantage of contributing to a pension over making a mortgage payment is the fact that the pension fund compounds tax-free

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But if

Brendan Burgess said:

Pensions are a great tax-efficient way to save for the future and nothing in this post says otherwise.

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But it's interesting that you didn't notice these, so I have to emphasise them more.

Itchy said:

Its more accurate to reflect that you could have: 120/140% of your money compounding vs. 100% of your money (with the ancillary benefits accruing faster but with opportunity cost).

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But that is not right either.

I am not suggesting that you make only mortgage repayments. I am suggesting that you make them ahead of making pension contributions. And if you reduce your mortgage now, you will have lower payments later, so you will be able to pay more into your pension fund then. So the tax relief going in is the same.

The tax advantage of making pension contributions now instead of making them in 5 years, when your mortgage is at a comfortable level, is that in the mean time, the pension fund return is tax free.

Brendan

Brendan Burgess said:

But it's interesting that you didn't notice these, so I have to emphasise them more.

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Ok. I don't think that's the correct interpretation of how I understood your posts at all. No need to re-emphasise the points you have made, I agree with them. My post was regarding the information that you have omitted, which by doing so does not enable a complete analysis.

Brendan Burgess said:

I haven't.

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I don't understand.

Brendan Burgess said:

If you make an AVC of €1,000 to your pension today, and you get a return of 3% a year, it will be worth €1,806.11 in twenty years.

But it's the exact same for a mortgage overpayment. If you make an overpayment of €1,000 today, and keep the rest of your repayments the same, your mortgage balance will be lower by €1,806.11 after 20 years.

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This is not an accurate representation of the financial picture.

OK, I see the point you are making.

The main point of the thread is to deal with the issue that paying down your mortgage compounds just as pension contributions compound.

Most people just point out "contributing to a pension compounds so you are missing out by not starting early" . I am trying to counter that, which is very misleading.

Brendan

Hi Brendan,

I’m not convinced by this at all.

It’s really important to consider the “use it or lose it” nature of pensions tax relief. If I don’t stick €28,750 into my pension fund this year, I lose that particular contribution threshold.

€28,750 invested for, say, 25 years grows to €97,000 based on a 5% growth rate.

€17,250 (i.e. the extra net income if you don’t make the pension contribution) overpaid against a 25 year mortgage at 2.5% saves €14,000 in interest and takes 1.5 years off the mortgage.

If I don’t stick €28,750 into my pension this year, I’m reducing its future value by €100,000. Versus shortening my mortgage term.

I just don’t see the logic.

Gordon

Gordon Gekko said:

It’s really important to consider the “use it or lose it” nature of pensions tax relief. If I don’t stick €28,750 into my pension fund this year, I lose that particular contribution threshold.

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There is a €2m pension fund threshold. If you can afford €29k p.a. into your pension, then you have plenty of time to avail of the maximum relief available, it is not lost by delaying.

Duke of Marmalade said:

There is a €2m pension fund threshold. If you can afford €29k p.a. into your pension, then you have plenty of time to avail of the maximum relief available, it is not lost by delaying.

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It is lost.

Company owners can make catch-up contributions but employees can’t.

If I don’t make my 2022 contribution, that individual window is lost.

Gordon Gekko said:

It is lost.

Company owners can make catch-up contributions but employees can’t.

If I don’t make my 2022 contribution, that individual window is lost.

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I am saying that if you can afford that level of contributions in your 30s you should be able to afford the max in your 40s and it is the the €2m fund cap that kicks in. If you reach the cap then you won’t regret missing the earlier reliefs, as you have maxed the relief anyway.

Duke of Marmalade said:

I am saying that if you can afford that level of contributions in your 30s you should be able to afford the max in your 40s and it is the the €2m fund cap that kicks in. If you reach the cap then you won’t regret missing the earlier reliefs, as you have maxed the relief anyway.

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I don’t agree.

Better and cheaper to frontload the contributions.

Brendan Burgess said:

The advantage of contributing to a pension over making a mortgage payment is the fact that the pension fund compounds tax-free.

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Matching payment are a significant additional advantage.

I nearly always advise collecting the free money from your employer (i.e. your employer matching your payment).

With the last 60 euro you have to invest this month you could pay 60 off your mortgage or put 200 in your pension (your 60 plus 40 tax relief plus your employer's matching 100).

You may argue that the 40 is not free money, it's only tax deferral, but your should compare the expected value of compounding 60 at your mortgage rate vs 200 in your pension.

Brendan Burgess said:

If you make an AVC of €1,000 to your pension today, and you get a return of 3% a year, it will be worth €1,806.11 in twenty years.

But it's the exact same for a mortgage overpayment. If you make an overpayment of €1,000 today, and keep the rest of your repayments the same, your mortgage balance will be lower by €1,806.11 after 20 years.

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Is the compounded pension growth rate after 20 years expected to be the same as the average mortgage rate over the 20 years? (Duke might confirm that CAGR for pension vs average mortgage rate is the correct way to compare!)

I (foolishly?) expect a 100 percent equity pension to trounce mortgage rate.

You may counter that the pension money still need to be taxed before we get our grubby paws on it, so calling them equal approximates for some tax cost at drawdown.