Introduction
If you don't belong to a company pension scheme or are self-employed, you can use
a personal pension plan as a tax-efficient way to save the cash lump sum necessary
to repay an interest-only mortgage whilst planning for your retirement at the same
time.
Not that many people are even aware that know that you can tie your mortgage to
your pension. Lenders are encouraged not to advertise this type of mortgage because
the government doesn't particularly want people to use their retirement fund to
pay off their mortgage. There is no doubt that only a minority of people will find
that pension mortgages are a suitable choice of product. Then again for some people,
such as a financially sophisticated self-employed higher rate taxpayer, they can
be ideal choice.
As with all the other types of interest-only mortgage, interest is paid to the lender
on the whole of the loan for the entire term of the mortgage. This choice of repayment
vehicle combines your mortgage interest payments with payments into your personal
pension fund. In itself, this feature of pension mortgages rules many people from
having them, as not everyone is eligible for a personal pension scheme. Company
pension schemes are not normally used, though they sometimes can be in special circumstances
if permitted by the lender.
Your payments go into your pension fund, which then grows over time. You will have
full control over your choice of pension product provider. However, your bank or
building society will expect the insurer to set predicted growth levels at a conservative
level to help ensure that there is enough in the fund to pay off your loan at retirement.
The pension plan is designed to mature on your retirement.
The loan term must end between the ages of 50 and 75 unless the borrower is in an
industry where the Inland Revenue permits earlier retirement.
The pension also needs to provide you with an income during retirement, so only
twenty five percent of the total pension fund can be taken as a lump sum. This lump
sum is used to pay off your mortgage while the remainder provides you with a pension
income. This means that you need to accumulate four times the value of your home
loan in your pension fund in order to pay off your mortgage. This may be difficult,
especially with a high value property.
You should consider getting a separate life insurance policy in case you pass away
before the pension matures. With this type of mortgage, level term assurance for
the value of the loan is normally used.
Advantages
Just as a pension is the most tax-efficient way of saving, it is also the most tax-efficient
method of paying back your mortgage. The premiums you pay into your personal pension
plan are subject to tax relief at your highest rate of tax. This makes use of a
pension plan particularly cheap for a higher rate taxpayer, as they will receive
tax-relief at 40% on their pension contributions.
Furthermore, as well as tax relief on interest paid to the lender, you get some
tax-relief on pension related life insurance, which means that you can make further
savings by arranging your life cover in conjunction with your mortgage.
The underlying pension fund is also tax-efficient, as it is not taxed on its investment
income or on the capital gains it makes when selling the investments held by the
fund in order to replace them with new shares or other financial instruments. This
tax efficiency should lead to a higher return on your investment than the same contributions
into an ISA or endowment.
There is nothing stopping you from contributing more than your required level of
repayment, as long as you are within your overall pension contribution limits. This
can leave you with a cash surplus left over from your mortgage repayment at retirement.
You can make these additional voluntary contributions when it suits you financially,
but there may be a minimum limit on the size of the extra payment.
You can also be left with a cash surplus on retirement if your pension fund outperforms
the level assumed at the start of the plan. Long periods of low interest rates can
increase the likelihood of this happening, as a greater portion of your monthly
payment will go towards your pension contribution and less will go towards meeting
your interest payments.
Disadvantages
Because of the need to accumulate four times the value of your home in the pension
plan, this type of repayment vehicle will require a significantly higher monthly
outlay than the other types of investment vehicle used with interest-only mortgages.
There are limits on the size of the contribution that you can make into your pension,
which can make reaching your required amount difficult, especially if you are buying
a very high-value property. Other people may not be able to afford to contribute
as much as their limit and also may struggle to reach the required fund value.
Not everyone qualifies for a personal pension, so this route is not available to
all - only the self-employed or anyone not in a company pension scheme can normally
use them. A problem arises if you change status and are no longer eligible for a
personal pension. You would have to switch to a different repayment vehicle and
may be penalised financially for this.
The benefits of your pension plan cannot be taken until retirement, usually until
you are at least 50 years of age. That means you are realistically stuck with this
type of mortgage until your retirement, making it the repayment method that requires
the most long-term viewpoint.
If you don't wish to retire at the end of your mortgage term, then you will end
up paying more interest on the loan than with other repayment vehicles. This is
likely to be the case if you start the pension mortgage more than twenty-five years
before your planned retirement date. You should also remember that you will get
a lower pension in retirement if all or part of your lump sum is used to pay of
your mortgage.
As with an ISA mortgage, tax-free investments are great in theory, but since pensions
are equity-linked it's not so great when the value of the investment is actually
falling, as may have been the case over the early years of this century.
Pensions are complicated to understand, with all sorts of rules and regulations
governing contributions. Given that many people are pretty lapse in ensuring their
pension arrangements are in order at the right time in their life, it is no surprise
that few people are mentally or financially ready to combine their mortgage with
a pension, instead preferring more simplistic methods of clearing the mortgage debt.