Interest-only mortgage time bomb: the implications of using your pension pot
Thousands of older homeowners have an interest-only mortgage and many are considering using their pension savings for their repayment strategy. Before making this move, here are the implications you need to be aware of.
Around 1.8 million UK homeowners currently have outstanding interest-only mortgages and around 10,000 borrowers a year between now and 2020 will come to the end of their loans.
Many people do not have an appropriate strategy to pay off the loan and it is estimated that around 300,000 homeowners aged between 51 and 65 are planning to use pension savings to pay off their mortgages.
Financial Conduct Authority-commissioned research suggests that those with a mortgage due for repayment have an average shortfall of £56,000.
If your mortgage is set to mature in the coming years and you don’t have a plan to pay off the remaining balance, here are the implications of using your pension pot to cover the shortfall.
Pension freedoms and tax
One of the reasons people are now considering using their pension pot to repay the interest-only mortgage is because of new pension flexibility.
Introduced in April 2015, pension freedoms changed the retirement landscape by allowing people approaching retirement unfettered access to their pension pots.
They give anyone aged 55 and over the ability to access as much of their pension savings as they want. The first 25% can be withdrawn tax-free and the remaining 75% is subject to the person’s marginal rate of income tax.
Claire Trott, head of pension strategy at Technical Connection, says: “A lot of people see significant sums of money sitting and growing in their pension pot and with the flexibility of pension freedoms, they can access more of it. Previously people were restricted with what they could take out in one year, but now, they can cash it all in.”
Another reason for the appeal of pensions is that many older homeowners are struggling to downsize in order to pay off the mortgage due to a shortage of suitable housing. In fact, older borrowers needing to deal with their interest-only debts have been a key driver in the growth of equity release business according to more 2 life. It’s even been described as a ‘lifeline’ for borrowers with no other repayment plan.
Helen Morrissey, personal finance specialist at Royal London, says: “Older borrowers may be concerned about being able to secure extra lending to service this debt as they could be paying it off well into their retirement years. If they have a sizeable pension pot then it can be tempting to use this to pay off the loan instead.”
However, Morrissey warns of the tax implications in using a pension pot to cover the balance.
She says: “There are two different ways that a pension fund can be drawn down. If you choose to take your pension pot in one go then 25% will be tax-free while the remaining 75% will be taxed. Alternatively the money can be taken in several slices with each slice being 25% tax-free and the remaining 75% being taxed.
“However, what people need to be aware of is that when taxable cash is taken from a pension scheme HM Revenue & Customs will charge emergency tax which means the amount of tax paid will be much higher. This can then be reclaimed but it is worth noting as the person will initially get a lower sum than they were expecting and this may affect their financial planning.”
See YourMoney.com’s Overtaxed on pension freedom withdrawals? How to reclaim your money for more information.
Pension pot may not cover balance
Trott says there’s also no guarantee that the pension pot will pay off the mortgage. “You can’t guarantee that the funds you need will be there. In the worst-case scenario, what would happen if the rules change and you can no longer access your money to pay off the loan? These are two totally separate areas of financial planning,” she says.
This point is echoed by Alex Brown, wealth management director and Mattioli Woods, who says savers shouldn’t rely on pension savings as this sector has experienced more tinkering than any other. “You are leaving yourself in the hands of government legislation. Contribution levels have been adjusted over the decade and there has been an adjustment on tax relief nearly every year in the last 10.”
Brown adds that even given the 25% tax-free lump sum people aged 55 and over can withdraw, it may not be enough to cover the repayment.
He says: “You need a significant pot to meet a repayment of £150,000 to £200,000 – it requires a pension pot of £600,000 to £800,000 for those planning to use the 25% tax-free lump sum. For the vast majority, just taking the tax-free lump sum won’t be sufficient, especially given the house price rises experienced by homeowners.”
Eat into retirement funds
Increases in life expectancy are stalling after 100 years of continuous progress, but nonetheless, those approaching retirement now can expect to live for two or even three decades as pensioners.
Morrissey says: “Thought needs to be given to how you are going to support yourself through retirement if you have used up a large portion of your pension in this way. Those who do this close to retirement age may find they have no time to rebuild their pot.
“Even those people who are prepared to try and rebuild their pension need to be aware that once they have taken taxable cash from their pension then they will trigger the Money Purchase Annual Allowance which means you can only contribute up to £4,000 a year into a defined contribution pension.”
She adds that people must also bear in mind that they’re potentially missing out on good levels of investment returns by taking money from their pension pot.
Pension pot as a last resort
For those who have no other option but to use their pension pot to cover the balance, all three experts urge borrows to see a financial adviser, and Morrissey says you could talk to your lender about extending the scope of the loan to enable you to pay back some of the capital.
Trott adds: “If people have got themselves in this situation, there are not very many options left. If people do have a serious issue regarding their property, they need to talk about it sooner rather than later. Take some advice, get some help and work out what the pros and cons are of this for your personal situation.”
However, one of the positives in this strategy is that the pension money is at least being put to good use. In recent times, experts have warned that a lack of trust is causing retirees to withdraw pension money only to deposit it in low interest paying accounts, meaning they’re missing out on investment growth.
Morrissey says: “Freedom and choice prompted many people to take their pensions as a lump sum not because they needed it but because they felt this gave them more control. However, many then put the money into bank accounts and cash ISAs which only offer low rates of interest. From this point of view it might be seen as more worthwhile to take the money and use it to pay off a sizeable mortgage debt rather than leave in a bank account earning very low interest.”