For those customers with an income drawdown pension (a more flexible form of personal pension) the changes to drawdown rules planned for April 2015 may help customers manage their finances in a different way.
With many interest only mortgages due to end during the coming years, many customers will find themselves in a position where they need to pay their mortgage lender back, but may have no ready money with which to do so. They may be tempted to take their entire pension fund as a lump sum and pay off their mortgage. But is this a sensible thing to do ?
While everybody’s circumstances will be different, repaying a mortgage this way could be a very expensive solution. No matter how big a lump sum you take, only the first 25% of your total pension fund value would be paid to you tax free, so for an example if you decided to take half of your pension fund to repay your interest only mortgage, half of the amount you receive will be tax free (being 25% of your total fund value), but the following half will be liable to income tax. This means that you could be giving 20% - 45% of it back to the tax man.
It would be a very good idea to pay off your mortgage with the tax free pension lump sum only. Therefore if your outstanding mortgage debt is £50,000, you would ideally need a pension fund of £200,000, which would then allow you to take the £50,000 you require tax free. Unfortunately, in our experience the average pension fund in the UK is worth between £40,000 - £100,000.
Even if you decide to pay the tax and use all of your fund to repay the mortgage, what are you going to live on in retirement? While you need to consider how you will repay the mortgage, it is equally important that you consider how you are going to fund a retirement that itself could last for 25 years or longer.
Our view is that you should formulate a plan long before you need to repay the mortgage. You should consider alternative products such as an equity release mortgage; your wider financial circumstances as well as any other action you could take. Can you afford to switch to a repayment mortgage now ?, Even if you can’t - all interest only mortgage lenders will allow you to make overpayments, which immediately comes off the debt. Setting up a regular overpayment will gradually have a longer term financial benefit. As the overall loan reduces, then the amount of interest you need to pay each month also reduces. This means that some of the money that you were using to pay the interest, now goes towards repaying the debt. Gradually as every month passes more of your original payment plus the overpayment goes towards reducing the debt.
It is also worth considering your family and what you want to happen after you are gone. If you die mortgage fee, then your home will pass to your children and estate. If you have an outstanding mortgage, including an equity release loan, then that will need to be repaid first and anything this is left will then be passed on. However if you are going to use all of your pension fund to repay the mortgage you may be sacrificing your quality of life in old age to leave in inheritance for your family.
If before you die you are taken into Long Term Care and the home is lost in any case to pay for it, both you and your family may have wished that you held on to your pension fund.