A question from a visitor asking for a view on whether to use their bonus payments to reduce their mortgage balance or add it to their pension pot.

Hi, been following your site for a while and wanted to ask a question, trying to get as many views as a I can.  We are in our late 20s and both earn bonuses each year, not massive, about £3k each.  Should we use these to reduce our mortgage or add it to our pensions?  We want do one or the other.

Your question is not uncommon.  I have asked myself the same in the past.  Whilst I can't advise you what to do, I can give you my views on what I consider to be worth considering.

Topping up your pension

Depending on your goals, you will need a lot in your pension pot when you retire.  Final salary pensions are a thing of the past now, and most plans out there simply need more and more money to pay out a decent retirement income.  Of course, you have a long time before you get to that stage.  You suggest 60 as an initial retirement point.  

Assume you have 30 years before you retire; assuming it's available, the state pension won't come until at least 67.  So you need to cover 7 or more years from retirement before benefitting from that.

You mentioned that the £6k joint bonuses are pre-tax.  You could put that in your pension without paying tax, so that's a benefit.  Then let's assume you continue to earn that bonus steadily over 30 years with a 2% increase each year.  Roughly, let's say that's about £240k put into your pensions, but many variables, such as growth, are not factored in.  In addition, I assume you both have a workplace pension and contribute monthly, so £240k is extra.

Clearly, an extra £240k will make a difference.  If you have a workplace pension, it usually has tools to allow you to model what the impact of that extra £240k could make.

However, in 30 years, £240k will not be worth anywhere near as much as it is today, so you must be careful to factor in inflation, growth, etc.  That is beyond the views I can provide.

Paying down your mortgage

You have not provided any mortgage details, so I can't see how bonuses would impact that. That said, if you take £6k each year, assume 25% deductions, leaving £4,500 you could pay to the mortgage each year, reducing your mortgage by £135,000. 

It's more complicated than that, of course. Each year, you will pay £4,500 to the mortgage, and in turn, that means even though your monthly payment does not change, the amount of interest paid each month reduces, and more is paid to the capital.  So each year, you pay £4,500, plus a bit more due to the saved interest.  Every year, the amount you pay to the mortgage goes up.

Suppose this means you pay the mortgage off after 20 years, at which point you will be 50 or thereabouts.  Now, at 50 with no mortgage, you can start ramping up your pension contributions.  So, let's say that for the next 10 years, you can start paying £6k to the pension as well as the amount you were paying to the mortgage.  Call that £500 per month, so another £6k, but you would be paying that free of tax as it's going into your pension, so it's actually about £8k each year.

In that 10 years, you are putting in about £180k. This is, of course, far less than the £240k you would have put in had you put the money into your pension over a much longer period. And you would still have paid off the mortgage by the time you get to 60.

I am making a lot of assumptions here to illustrate, but there are important factors I have not considered, and they must be.

A balanced approach to both

Assuming you both have an income of 60, there is a balanced approach.  You keep making your standard contributions to pensions whilst paying your mortgage each month, putting some bonus payments into the mortgage and some into the pension.

Much of what I have done above ignores factors we must consider.

Assuming you are both in employment for the next 30 years, that income will go up.  Whether it's through a new role, annual increases or promotion.  So your disposable income should go up as well.  Those bonuses may also rise more than the 2% I have allowed.  In 10 years, you could jointly earn bonuses of £10k or even individually.  This changes things a lot. 

By the time you are both 50, that income could have doubled, and there could be significantly higher bonuses. The amount you could put into pensions in that 10 years, from 50 to 60, could be way higher than anything I have suggested above. By that time, you may already have paid off the mortgage, so you can ramp up those pension contributions.

Of course, it may not!

My earnings from 30 to 50 had tripled, and my mortgage was paid. The amount my employer and I contribute is now quite significant.

Life!

You also have to factor in life.  That is, you can't predict what is around the next corner.  Redunandcy leads to gaps in income and loss of bonuses.  Children and many other factors all impact what you can achieve.  What if you want a bigger house and need a bigger mortgage?

It's never as simple as modelling. You need to determine what is most important to you.  Maybe you could pay off the mortgage by 40, giving you 20 years to focus on the pension instead of 10.

It's a difficult decision early in life; I commend you for thinking that far ahead.  I recommend contacting a financial advisor to help model the various circumstances.  Paying a professional to model the various scenarios clearly will be a big help.

Good luck in whatever you decide.