pension or mortgage

As a young person, unless you have progressed to the higher pay echelons quickly, you will have a limited amount of money left over each month after paying the typical expenses such as rent, food, utilities and travel.

Despite this, you are being given messages about the importance of both getting on the property ladder, and of saving into a pension. So just what is the best choice for a young person?

If this were a straightforward question to answer then this article would end right about now with a nice succinct statement, but there are a number of factors to consider before you decide the balance between saving for a deposit and saving for your retirement.

The Arguments For Getting A Mortgage Early

Buying a house is likely to be the single biggest purchase that you ever make and for many it is one of their main goals in life. Home ownership is seen as something that will typically pay off in the long term and that by taking this step, you are setting yourself up for a more comfortable retirement. But is this true? Let’s have a look at some of the main benefits of getting on the ladder sooner rather than later.

Lower Deposits Required

You may be thinking that an increase in house prices is great because it makes you richer on paper, but this is only true if you were to sell the property and downsize to release some of the equity that has built up.

Instead, one reason that changes in house prices are important is because in the medium term, they will almost certainly rise (see the graph of average UK house prices above) which means that the longer it takes you to save for a deposit, the larger it is going to have to be. In other words, putting all of your spare cash aside for a deposit will allow you to buy a home sooner (sounds obvious doesn’t it?) Or alternatively, if you take longer to save up a deposit, you may have to settle for something a bit smaller, or a property that is not in your ideal location.

Lower Total Mortgage Amount

Another reason why getting a mortgage as soon as you can is good for your long term finances is that the total size of the mortgage you have to get is likely to be smaller. If you wait 5 years before buying a home, the average price of a property might have risen by 20% – 40% or more (they can also go down of course).

Therefore, if you manage to buy sooner rather than later, a smaller overall mortgage will mean that your monthly repayments will be lower. With this being the case, you will have a larger amount of disposable income and so you can then put more money into a pension at this point.

For example, a £200,000 mortgage over 25 years with an interest rate of 4% would result in monthly repayments of £1,056 and a total repayment of £316,702.

Wait a year and the same property might require a mortgage of £210,000 and with the same term and interest, it gives monthly repayments of £1,108 and a total of £332,537.

That’s £52 a month difference which could go into a pension. It totals £15,835 over the term of the mortgage (£10,000 of that is the rise in the price of the property; the remaining £5,835 is the extra interest you end up paying).

Alternatively, a smaller total mortgage will allow you to choose a shorter repayment period which will result in lower overall repayments over the full term. The less you pay in total for your mortgage, the more you will have to put into a pension.

Let’s say that you can afford monthly repayments of £800. If you require a mortgage of £150,000 at 4% then you can have a repayment period of 25 years and the total bill comes to £237,527.

If you have to wait a couple of years because you are saving into a pension too, then the size of your mortgage could be £165,000 and at the same interest rate, this requires a 29 year term and results in a total repayment of £279,046.

So the delay in making the purchase not only led to a house price rise, but the resulting impact on the length of mortgage means that your total interest repayment is £26,519 higher too.

And finally, having a smaller mortgage with the same size deposit will mean that your loan-to-value (LTV) will be lower too. In other words, the percentage of the value of the property that is paid for by the mortgage is lower. The LTV plays a role in the interest rates that you will get offered by lenders, and so saving all of your money into a deposit will mean that your LTV is better and you will get better interests rates.

To illustrate the impact that interest rates can have on overall repayments, let’s take a mortgage of £200,000 over a period of 30 years and assume that the two different rates on offer are 3.5% and 4%. At the lower rate, you will repay £300,374 but, at just 0.5% more, this becomes £316,702 – an increase of £16,328.

So as you can see, by saving hard and getting on the property ladder sooner, you can enjoy a smaller total mortgage (assuming house prices rise), a shorter mortgage term and a lower rate of interest. Put all of these things together and the savings you make are considerable.

Rental Prices Tend To Be Higher Than Mortgage Repayments

For a large number of people, the amount of money that they would have to pay in rent surpasses the likely mortgage repayments they would face for a similar property. So by managing to buy a home, you can take the money that you save on rent and put it into a pension at this later date.

Another consideration is that, assuming a constant interest rate, your mortgage repayments will not increase. This is in stark contrast to rents which are likely to rise – you are, in effect, at the mercy of the rental market and the whim of your landlord.

Home Ownership Upon Retirement

Let’s take the extreme example where you never put any money away for a deposit, but instead take it all and invest it in a pension. You may end up with a larger pension pot come your retirement (although this is not guaranteed), but you will not own a home.

This will leave you having to pay rent which will eat away at everything that you’ve managed to squirrel away over time. Or, you may find that the level of income from your pension is not enough to fund a property of a size to which you are accustomed.

Conversely, owning your home outright at the point of retirement will mean that all income received from your pension and any other savings you have can be spent on other things or kept aside for a rainy day.

The Arguments For Saving Into A Pension

Once all is said and done, the fact of the matter is that come your retirement, you will have to live off the amount of money that you have accrued in your pension (plus the state pension if you qualify for it) and any other savings you have at this point.

Therefore, it is very important that you put money into a pension at some point during your life so that when you come to cash it out, it is enough for you to live off. But this article aims to answer the question of whether it is better to save early or to try and buy property as soon as possible.

So let’s have a look at some of the reasons why saving some money into a pension early might be a good idea.

The Effects Of Compound Growth

When you put money into a pension, it doesn’t just sit there waiting for you to use it when you retire. Instead, in a good pension fund, it will grow year on year for a period of 40 years or more (depending on when you start saving and at what age you intend to retire).

A relatively modest rate of growth can take the money that you are saving and turn it into something much much larger.

Let’s assume that you were to put a lump sum of £3,000 into a pension and that the annual rate of growth was, on average, 3%. After 40 years, your initial savings would be worth £9,786.11 which is more than 200% extra for you to utilise in your retirement. Here’s a graph of the total pension pot over this period:

Similarly, if you were to save £200 a month into a pension over 40 years, then you might expect to have built up a £144,000 pot, but if you were to compound the interest monthly then you’ll actually find yourself with £278,512.39 – almost double what you put in.

So by getting some money into a pension early, you are able to benefit most from the effects of compound interest. This becomes even more evident when you consider the amount you’d get back from that same £3,000 initial investment if you delayed it by 5 or 10 years. If the money is invested for 35 years instead of 40, you will get £1344.52 less in interest and if you only have the money in a pension for 30 years then you will receive £2504.32 less.

You see, the biggest absolute increases in the total pot occur in the latter years; that’s just how compound interest works. So the first year’s interest, based again on our £3,000 lump sum and 3% growth, is £90 while the 40th year’s interest is £285.03.

Employer Contributions

Many people in work will now find that they are enrolled in a pension scheme automatically by their employer and this has some real benefits.

By law, your employer will have to contribute to your pension pot although many companies have been offering such deals for a long time. It is not uncommon for an employer to match any amount that the employee pays into a pension. This is, essentially, free money as it neither affects your salary or the rate of tax you pay.

If you pay £150,000 into a workplace pension over the course of your career and your employer matches this, then you will end up with £300,000 in total. Sounds good doesn’t it?

Government Tax Relief

The government wants people to save into a pension and they incentivise this by offering tax relief on the money that you put in.

You can claim tax relief that is worth up to 100% of your annual earnings with the maximum being £40,000. Thus, if you have additional savings or receive some other lump sum that you want to invest, don’t put it all straight into your pension; stagger your payments across multiple tax years so that you do not cross this threshold, or you will lose the tax relief on any amount over the limit.

Your pension provider will automatically claim the basic rate of 20% tax relief for you when you save – this is known as “relief at source” – but if you are a higher rate taxpayer, then you can reclaim the additional 20% (or more if you are in the highest band) through your self assessment.

Tax relief is not an additional amount that is added to your own contributions, but rather an amount that you get back from them. In other words, a 20% tax relief on a saving of £10,000 means that you effectively get £2,000 back because the government pays it instead and you only pay £8,000. This is in contrast to the government adding 20% extra, which on £8,000 would only amount to £9,600 (i.e. you actually get 25% extra on top of what you put into the pot).

A 40% taxpayer would only have to contribute £6,000 to get £10,000 in total, while any higher rates of tax than this will mean even higher tax relief (within the above limits).

Put It All Together

If you combine the effects of employer contributions and tax relief and apply compound interest to it, then you’ll soon see how a relatively modest personal contribution can quickly add up to a significant pension pot over time.

This, then, is why putting some money away into a pension as soon as you can is a sensible approach to take to funding your retirement.

So What Should I Do? Save To Purchase Property Or Save Into A Pension

As stated earlier, this question is not one to which there is a straightforward answer. You have to weigh up a lot of factors before you can come to any solid conclusions; these include:

  • The amount of rent you currently pay versus the likely amount you’d pay in mortgage repayments – any difference can be put into a pension after all.
  • The expected rate of house price inflation over the coming 5 to 10 years – if this is relatively low (or even negative) then the argument for saving for a deposit becomes weaker, but if it is high then you should probably do all you can to save for a deposit at the expense of saving into a pension.
  • The expected increase in rental prices – if this is significant then you will probably be better off getting a mortgage sooner rather than later.
  • The expected growth rate of your pension – a government report in 2012 suggested that medium term rates of return will be lower than they were previously.
  • The difference in mortgage interest rates for varying loan-to-value percentages – if there are particularly attractive (low) interest rates for those with a bigger deposit relative to their mortgage, then saving for this bigger deposit is a generally smart move. If there is little difference then you can probably aim for a smaller deposit.

Right now, it is the opinion of this website, that for a young person who eventually wants to buy a home of their own, any money that they can put aside should go towards a deposit rather than into a pension. We say this primarily because of current and expected house price inflation and the historically low interest rates that are leading to some very attractive fixed rate mortgage deals.

This recommendation may change in the future based on how these and other things change.

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