I purchased a buy-to-let in 2007 with a 25-year interest only mortgage, which now has just over seven years remaining.
The mortgage balance is now £117,000. It is currently on a variable rate, but I am considering fixing for two years with the same bank in order to reduce my monthly payments as I think that interest rates will be slow to fall.
But I have recently retired and took a lump sum from my pension. I am considering selling the property in 2032 at the end of the mortgage.
Instead of remortgaging, should I consider using some of the lump sum to pay off the property now?
The alternative is to keep the lump sum and pay off the mortgage via the sale of the property in seven years, when the mortgage term ends.
If I did that, would I pay less capital gains tax, because I would be paying a chunk of the property’s value back to the mortgage lender and not benefiting from it myself?
Property problem: Our reader is considering whether to use up a pension lump sum to pay off his buy-to-let mortgage, which has seven years left to run
Ed Magnus of This is Money replies: Although you bought just this property before the 2008 housing crash, hopefully your rental property will have proved to have been a good investment over the long term.
There is a sizeable interest-only mortgage on the property, which you say is on a variable rate.
While current forecasts suggest the Bank of England will cut interest rates from 4.75 per cent to either 4 per cent or 3.75 per cent by the end of this year, there is no guarantee that will happen.
Forecasts are often wrong. At the start of 2024, markets were predicting the central bank would cut interest rates six times over the course of the year. It ended up being only two in the end with rates falling from 5.25 per cent to 4.75 per cent.
At present, the average two-year fix on a buy-to-let mortgage is 5.34 per cent, according to Moneyfacts. On a £117,000 interest only mortgage that would equate to £520 a month.
Depending on your situation, the property type and the level of equity you have in the property, you may be able to do much better than the average rate.
The cheapest two-year fixed rate buy-to-let mortgages with some of the big banks are below 5 per cent.
For example, Virgin Money is charging 4.54 on a two-year fix with a 1 per cent arrangement fee. On your £117,000 mortgage that would mean paying £443 a month on interest-only.
It would be worth speaking to a mortgage broker to assess your options.
Paying off some of the mortgage early using a pension lump sum could be a good idea if you are looking to de-risk your finances.
However, your capital gains tax liability won’t change, whether you pay the mortgage off via a lump sum or through the sale of the property.
For expert advice, we spoke to Karen Noye, mortgage expert at Quilter and Elena Todorova, director of mortgage broker SPF Private Clients.
What are the capital gains tax rules?
Elena Todorova replies: Surprisingly, the amount of capital gains tax is not linked to the amount of debt you hold on the property.
Capital gains are broadly calculated by deducting the purchase price from the sale price, as well as any expenses such as stamp duty, estate agent fees, legal fees and the costs of structural improvements.
It makes no difference whether you have a mortgage to pay back at the point of sale.
His Majesty’s Revenue and Customs is interested in the increase in the value of the asset and not if there are any liabilities attached to it.
You cannot deduct any money spent on routine repair and maintenance of the property, either.
Karen Noye , mortgage expert at Quilter
Should they pay the mortgage with their pension lump sum?
Karen Noye replies: If you use your pension lump sum to pay off some or all of the mortgage, it won’t directly affect how CGT is calculated.
You are right that predictions are that interest rates are likely to come down relatively slowly.
However, this is just a prediction so making a decision based on your current finances is the best course of action.
It’s also worth remembering that, since 2020, landlords can no longer deduct mortgage interest from rental income.
Instead, you get a 20 per cent tax credit on your mortgage interest, which may impact your finances.
Using your pension to reduce the mortgage could lower your monthly costs, but it’s crucial to consider how this might affect your retirement plans and quality of life as you get older.
Elena Todorova adds: With regards to using your lump sum to reduce the loan, this will have an impact on the potential tax credit you can claim on your tax return.
Technically, the smaller the loan, the lower the tax credit and the higher the taxes you would pay on the rental income.
Elena Todorova , director of mortgage broker SPF Private Clients
You also have to consider the alternative cost. Would it be better to leave the funds in your pension where they can grow in a tax-beneficial environment, and generate a higher pension return?
Or reduce your pension, which will generate a lower monthly income but save a certain amount on the interest rate?
Withdrawing pension monies will have a longer-term impact on your pension and making repayments now will result in an immediate reduction in the mortgage you are paying.
Before you make any final decision, I would recommend speaking to a tax adviser, financial adviser and of course a mortgage broker.
Should they fix their variable mortgage rate?
Karen Noye replies: If you do decide to stick with the mortgage and not pay it off, switching to a fixed rate would give you more predictable payments and could save you money in the short-term.
If you took a two-year fix, you’d have the option to reassess when rates might be lower.
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