Overpay the mortgage, ISA or pension - which is best?

It’s the classic ‘trilemma’, particularly for those in their 40s and 50s: should you overpay your mortgage, invest in an ISA or pay more into your pension?

With interest rates higher than they have been for much of the past 10 years, it may be tempting to take the guaranteed return of overpaying your mortgage over the unpredictability of stock markets.

However, our number crunching suggests that doing so could potentially leave you £33,000 worse off after 20 years.

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Mortgage, ISA or pension?

Let’s take an example. Emma is 45 earning £40,000 a year with £300 a month in excess savings.

She has £150,000 in her pension already and £100,000 left to repay on her mortgage over the next 15 years. Her mortgage rate is 4%.

Emma considers three options for her excess savings:

1. Put it towards overpaying her mortgage (once the mortgage is paid off, she puts the £300 a month into her pension)
2. Put it into a stocks and shares ISA 
3. Put it into her pension

We assume in all scenarios that she is putting 5% of her pay into her pension and her employer puts in 3% - with any additional contributions being on top of that. We also assume her salary goes up by 2% per year until she retires at age 65.

We modelled what might happen in the 20 years until Emma’s retirement in each scenario.

Option 1: overpay the mortgage

If Emma takes option 1, she clears her mortgage 5 years earlier than expected (by age 55). The £300 a month net contribution she makes to her pension after that would help to grow her pension pot to £427,577 by the end of the 20 years.

She also has £80,294 in cash, thanks to the debt interest saved from repaying her mortgage early and to the increases she has enjoyed to her salary.

Her total financial wealth is now £507,871, assuming no other savings or investments and not including her property.

Option 2: invest in an ISA

If Emma invests her £300 per month into an ISA, she still clears her mortgage in 15 years (by age 60) as per her repayment plan. By the time she retires, she would also have investments in her stocks and shares ISA worth £85,469 and a pension worth £376,218.

On top of that, she has cash savings of £53,476 thanks to her salary increases.

Her combined financial wealth is now £515,163.

Option 3: pay into a pension

If Emma takes option 3 and puts the £300 a month into her pension, she would leave work with a retirement pot of £498,866.

As with the other two scenarios, she would have cleared her mortgage by the end of her repayment plan - but with option 3 she ends up with significantly more in her pension.

That is partly down to the fact that, in option 3, Emma invests in her pension earlier - giving the investments more time to grow. It’s also thanks to the generous income tax relief Emma gets on her pension, which means the government tops up her £300 a month contribution by 20%.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). Eligibility to invest in an ISA and tax treatment depends on personal circumstances and all tax rules may change in the future. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.