Comparing mortgage returns to investment returns if in Drawdown

Pat38493

Hi - I am just trying to think something through around whether to pay off my mortgage (or some of it).  Rate is 3.54%.

Generally I was comparing the investment returns I am making to the mortgage interest rate.

However, if most of my growth investments are in a drawdown pot, and I expect withdrawals to be at a 20% tax rate, does this mean that actually I have to achieve 4.425% returns inside the drawdown fund in order to match the mortgage interest as I will pay 20% tax on that growth?

Voyager2002

Pat38493 said:

Hi - I am just trying to think something through around whether to pay off my mortgage (or some of it).  Rate is 3.54%.

Generally I was comparing the investment returns I am making to the mortgage interest rate.

However, if most of my growth investments are in a drawdown pot, and I expect withdrawals to be at a 20% tax rate, does this mean that actually I have to achieve 4.425% returns inside the drawdown fund in order to match the mortgage interest as I will pay 20% tax on that growth?

That is approximately correct, but the return you would have to achieve is less than that. Remember that 25 per cent of withdrawals from your pension pot will be free of tax. And of course your gains within a pension fund are compounded so long as they remain invested.

dunstonh

However, if most of my growth investments are in a drawdown pot, and I expect withdrawals to be at a 20% tax rate, does this mean that actually I have to achieve 4.425% returns inside the drawdown fund in order to match the mortgage interest as I will pay 20% tax on that growth?

The tax wouldn't be 20%.  It would equate to 15%.   25% is tax free, 75% is taxable.    And the taxable bit is only the amount above the personal allowance.   If it falls within the personal allowance, that would be free of tax too.

Pat38493

dunstonh said:

However, if most of my growth investments are in a drawdown pot, and I expect withdrawals to be at a 20% tax rate, does this mean that actually I have to achieve 4.425% returns inside the drawdown fund in order to match the mortgage interest as I will pay 20% tax on that growth?

The tax wouldn't be 20%.  It would equate to 15%.   25% is tax free, 75% is taxable.    And the taxable bit is only the amount above the personal allowance.   If it falls within the personal allowance, that would be free of tax too.

In my case i think it would because I will have DB pension using my personal allowance, and I have already taken the TFC from my biggest pension.  That said, I am still building up pension in my employer fund so it's a good point.

ukdw

I am not sure you need to factor in tax when comparing average growth rates to mortgage interest - as surely you would still have to pay tax to withdraw the money to pay off the mortgage - probably at a slightly higher average rate than you would if you left the income invested and drew it down more slowly - as more of it would be within the tax free band.

Pat38493

ukdw said:

I am not sure you need to factor in tax when comparing average growth rates to mortgage interest - as surely you would still have to pay tax to withdraw the money to pay off the mortgage - probably at a slightly higher average rate than you would if you left the income invested and drew it down more slowly - as more of it would be within the tax free band.

Interesting point.  Thing is though, I have a choice whether to withdraw money from my drawdown pension to pay off my mortgage faster.  The monthly mortgage payments would be coming from taxable money also, but there I don't have a choice.  

On the other hand, once I am retired and relying only on pension income, I also don't have a choice but to take drawdown money to pay the monthly mortgage payments so I will then be paying interest on the smaller payments for a longer time.  That's partly why I posted the question because I was unsure whether I should factor in tax to the growth depending on whether the mortgage payoff would come from a drawdown pot or not.

I guess maybe a lot of folks would use a PCLS to pay off their mortgage so then it's a moot point.

Secret2ndAccount

We have incomplete information.  Are you still earning and therefore able to contribute to a pension?  Or are you retired and therefore deciding between drawdown now or drawdown later to pay off the mortgage?
If it's the latter, then you simply have to beat the mortgage interest rate of 3.54%. You are going to be taxed (at 15%, or in your case if you've used up your TFLS 20%) either now or later. It only gets more complicated if the tax rate changes, e.g. if you hit the 40% rate, or the government substantially changes the basic rate. So, if you can grow your pot at 3.6%, better to let the mortgage ride. If your mortgage rate were to go up to 6%, might be time to draw out just enough cash to take you up to the 40% threshold, and pay it off the mortgage. If you can foresee your mortgage rate increasing beyond your growth rate, you might want to start paying the prinicipal down now as there is a limit to how much you can draw down each year without seeing a large tax bill.
All of this assumes you are in drawdown.
If you are still earning, and paying in to your pension, it changes the calculation slightly. Suppose you earn £1000. Your choice is to pay £800 off the mortgage today, or £850 off it later. Don't think about the fact you already used your TFLS for something else. Each £1000 paid in comes with its own fresh 25% TFLS. So if you could do this in one year, you've already made >6% which beats paying down the mortgage. But you only get this 6% once. If you go 5 yrs before you pay off the mortgage, you've only added about 1% per year to your growth. So you need to get your pot growth in the same ballpark as the mortgage rate, but the 6% uplift will tilt the balance in favour of keeping the money in the pension unless the mortgage rate gets quite high.
I know neither your expected annual income nor your remaining mortgage. I am wondering if you are going to grow your pot inside the pension, then be unable to get the money out to pay down the mortgage because you have no headroom to the 40% tax bracket. You need to pick some growth and interest rate numbers and model this all the way to the end of the mortgage to get a feel for how long this is going to take.

ukdw

Pat38493 said:

ukdw said:

I am not sure you need to factor in tax when comparing average growth rates to mortgage interest - as surely you would still have to pay tax to withdraw the money to pay off the mortgage - probably at a slightly higher average rate than you would if you left the income invested and drew it down more slowly - as more of it would be within the tax free band.

Interesting point.  Thing is though, I have a choice whether to withdraw money from my drawdown pension to pay off my mortgage faster.  The monthly mortgage payments would be coming from taxable money also, but there I don't have a choice.  

On the other hand, once I am retired and relying only on pension income, I also don't have a choice but to take drawdown money to pay the monthly mortgage payments so I will then be paying interest on the smaller payments for a longer time.  That's partly why I posted the question because I was unsure whether I should factor in tax to the growth depending on whether the mortgage payoff would come from a drawdown pot or not.

I guess maybe a lot of folks would use a PCLS to pay off their mortgage so then it's a moot point.

I tend to create a year by year spreadsheet to answer this type of question.

I would plot out every year until the mortgage is paid off - with columns for both options and accumulated totals showing the likely total pension pot left.   I would include tax calculations, growth and interest rate assumptions - then it should be fairly easy to see which option ends up with the largest total.

For growth comparison I don't think tax rates are significant (as post tax amounts available will still increase by the same percentage as pre tax amounts) other than where growth pushes you into different bands.

I.e. For 10% growth for example, with 20% tax.  Gross £100 - plus 10% growth is £110.    If you pay 20% tax on that then £80 will increase to £110 x 0.8 = £88  - which is still a 10% increase.

leosayer

If you have earmarked some of your drawdown for paying off the mortgage then have you considered taking it as income now (ie. paying the 20% tax now) and loading up your (and spouse's?) ISAs?

Any future returns will then be tax-free.

Pat38493

Secret2ndAccount said:

We have incomplete information.  Are you still earning and therefore able to contribute to a pension?  Or are you retired and therefore deciding between drawdown now or drawdown later to pay off the mortgage?
If it's the latter, then you simply have to beat the mortgage interest rate of 3.54%. You are going to be taxed (at 15%, or in your case if you've used up your TFLS 20%) either now or later. It only gets more complicated if the tax rate changes, e.g. if you hit the 40% rate, or the government substantially changes the basic rate. So, if you can grow your pot at 3.6%, better to let the mortgage ride. If your mortgage rate were to go up to 6%, might be time to draw out just enough cash to take you up to the 40% threshold, and pay it off the mortgage. If you can foresee your mortgage rate increasing beyond your growth rate, you might want to start paying the prinicipal down now as there is a limit to how much you can draw down each year without seeing a large tax bill.
All of this assumes you are in drawdown.
If you are still earning, and paying in to your pension, it changes the calculation slightly. Suppose you earn £1000. Your choice is to pay £800 off the mortgage today, or £850 off it later. Don't think about the fact you already used your TFLS for something else. Each £1000 paid in comes with its own fresh 25% TFLS. So if you could do this in one year, you've already made >6% which beats paying down the mortgage. But you only get this 6% once. If you go 5 yrs before you pay off the mortgage, you've only added about 1% per year to your growth. So you need to get your pot growth in the same ballpark as the mortgage rate, but the 6% uplift will tilt the balance in favour of keeping the money in the pension unless the mortgage rate gets quite high.
I know neither your expected annual income nor your remaining mortgage. I am wondering if you are going to grow your pot inside the pension, then be unable to get the money out to pay down the mortgage because you have no headroom to the 40% tax bracket. You need to pick some growth and interest rate numbers and model this all the way to the end of the mortgage to get a feel for how long this is going to take.

Thanks for the hints this makes it clearer.

To answer the question I am still working and still contributing heavily but I intend to stop working probably next May, or at least going part time.  Currently I am paying 80% of my salary into the pension and running down savings but this is planned to  reduce to about 17% from October onwards.  My income including bonuses and so on is around £115K so I am in 40% tax bracket for sure unless contributing a huge amount to the pension.

I have already transferred most of my pension as of January this year into an II fund and I took the tax free cash on that earlier this year so it's in drawdown.  I used part of the TFC to pay for 50% of a car to get a 0% 3 year deal (I expect this car to last 10 years).  I used another part of it to pay off about 25% of the remaining mortgage balance.  The rest is not yet spent.

Currently I have about:
£50K outside the pension mainly in cash/savings small amount in bonds.
£345K in II in drawdown. (100% equities)
£35K in Aegon in cash and bonds.  This is the employer fund expected to incrase to circa £90K by next May.  Uncrystallised.
DB pension worth about £13K per year if taking £90K PCLS if taking DB pension next January (9/4 years early for different tranches).
Wife has DB NHS pension 37K already in payment.
I am 55 yo wife 58.
2 x full SP (wife needs to top up 2 years before reaching 67).

Remaining mortgage is about £75K running on a 3.54% deal, ending August next year.  I have the option to pay off a further 27K in August.

My current plan using Timeline and Voyant Go is to pay off the mortgage in full by putting the DB into payment early and taking PCLS.  Keeping the mortgage going makes very little difference to the overall plan.  

PCLS is partly to pay off mortgage, and partly to have a buffer to avoid paying 40% tax in early years.

I am just wondering whether I should re-mortgage if returns are still look significantly above 3.54% next year that's all.

My spending requirements in retirement are pretty front loaded.  I need to spend about £65K in each of the next 2-3 years if the mortgage is still open.  I am also planning capital spend of about £30k to buy a caravan next year.

House is currently on the market for potential downsize, but this is not assumed in my numbers - assumption is the proceeds from downsize would be set aside to help kids in future but can also be an emergency buffer in worst case.

However once mortgage, university and car loan are finished by 2026/27, it will go down to long term spending of about 33K per year (combined couple assumption £65.5K).

According to Timeline even if I stopped work today we have 93% chance of being fine.  Working till around next May/June makes it 100% (obviously this number would change if there is a market crash before the next annual update of the numbers, but I guess you have to decide to retire based on a point in time and any crash after that is part of the planned items).

The downside is, if I run out of money, it will probably be at age 65-66 rather than age 90 or suchlike due to 2xSP kicking in later which covers almost all our needs.

Whether I pay off the mortgage early or not seems to make almost no difference to the % chance of success, but of course I don't know what future interest rates will be.

(also yes I am aware of pension recycling rules and my pension contributions this year won't be more than 30% higher than what they were in previous several years).