New figures from the British Bankers Association (BBA) show thousands of people are planning to use their pension to repay their mortgage. But, possible future changes to pension legislation, could leave these borrowers with no way of repaying their mortgage, potentially causing financial hardship in retirement.
The BBA’s figures show just over 2.5 million interest-only mortgages outstanding in 2012, down from over 3.5 million at the height of the housing boom in 2007. However, the number of pension mortgages has actually risen, from 62,000 to 82,000 over the same period; an increase of 30%.
What is a pension mortgage?
Interest-only mortgages were traditionally backed by a savings vehicle, such as an endowment, ISA (Individual Savings Account) or PEP (Personal Equity Plan), although pensions were also used.
With a pension mortgage the borrower uses the tax-free lump sum, usually 25% of the fund, to repay the mortgage debt. The tax-free lump sum cannot be taken before the age of 55 and of course using the lump sum to repay debt will reduce the income available in retirement.
A pension mortgage is certainly a tax-efficient way of repaying debt, after all endowments and ISAs don’t currently qualify for tax-relief, but there are many downsides too:
- Because the maximum tax-free lump sum is 25% the fund will usually need to be large; to repay a typical £100,000 mortgage a pension fund of £400,000 would be needed, well above the average in the UK
- The mortgage cannot be repaid before the age of 55, the earliest at which a pension can usually be taken
- By accessing the tax-free cash, any lump sum paid on death, immediately becomes less tax-efficient
- Using the tax-free lump sum to repay debt will inevitably reduce the income available in retirement
But the main problem with using a pension to repay your mortgage is that you are relying on the rules remaining unchanged for many years, something unheard of in the ever changing world of pensions!
Tax-free lump sum to be cut?
Almost without exception the run up to every Budget and Autumn Statement sees the financial pages awash with stories of pension tax-relief being reduced and the tax-free lump sum being cut.
Most people could cope with tax-relief on pensions being changed, it would only apply to future contributions. But, limiting the amount of tax-free cash available from pensions would have dire consequences for most people with a pension mortgage and it seems as though this is being considered.
Firstly, the Fabien Society, a left of centre ‘think tank’, has recently suggested the tax-free lump sum should be limited to £36,000, raising an extra £2 billion each year.
Secondly, and perhaps more worryingly, the Sunday Telegraph reported last weekend that the Treasury was considering cutting the tax-free lump sum available from pensions.
Of course neither of these ideas may make it into a future Budget or Autumn Statement, but thousands of people planning to use a pension to repay their mortgage, should be thinking about making alternative arrangements.
Alternatives to a pension mortgage
So, if you are one of the 82,000 people planning to use your pension to repay your mortgage, what are your options?
- Do nothing and hope the rules don’t change
- If you are over the age of 55 you could take your tax-free lump sum now and repay some or all of the debt. This is a drastic measure and has many downsides, not least your retirement income will be reduced, as will be the amount paid to your financial dependents should you die sooner than expected. This option is probably a last resort and should only ever be considered after you have taken independent financial advice
- Consider using other savings or investments to repay the debt
- Consider switching your mortgage onto a Capital Repayment basis. This will push up your monthly mortgage repayments, but you may well be able to reduce the payments into your pension, particularly if you were paying in relatively large amounts to ensure you had enough tax-free cash to repay your mortgage
If you were planning to use your pension to repay your mortgage the key is to take action sooner rather than later. Consider your options, decide which works best for you and take action.
Remember too, if you decide to change strategy and use an alternative method of repaying your mortgage debt, you’ll be left with more tax-free cash to spend on other things, or increase your income in retirement.
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Our team of Independent Financial Advisers are experienced in developing retirement income strategies for clients the length and breadth of the UK. If you are approaching retirement and would like advice on your options call one of our IFAs today on 0115 933 8433, alternatively enquire online or email firstname.lastname@example.org