Should I use a tax-free pension lump sum to pay down my mortgage before I retire?

I hope to get your opinion on my situation. I am 58 years old and my mortgage will continue for another nine years until I am 67.

The loan is currently at a fixed rate of 1.78 per cent until August 2025. I still have £158,000 to pay and I am slightly overpaying at £200 a month. My normal payment is £1,396.00 per month and I am currently paying £1,596.00. I am also aiming to save around £10,000 to £15,000 over the next two years.

I think I will have about £122,000 on my mortgage by the time I need to re-mortgage and I think I will need a £110,000 loan.

I also have a direct contribution pension, which I think will be worth around £170,000 by 2025. Should I take my 25 percent tax-free lump sum payment from that pension and use it to reduce the amount of interest I would have to pay on the mortgage?

If all goes well, I expect to pay off way too much mortgage from 2025 to 2028 and I want to be mortgage-free around 2028, when I’m 63.

I have a defined benefit pension of around £6,000 a year when I am 65 and possibly a small inheritance of £4,000. The latter is the unknown and will determine the year in which I can actually retire. Via email

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David Hollingworth replies: Many borrowers are currently locked into very low fixed rates that will provide invaluable protection against recent interest rate hikes.

With fixed rates now well above 5 percent or even 6 percent, depending on the term, those still stuck with a low fixed rate will be thankful for the buffer against rising costs.

While your current rate of 1.78 percent is in stark contrast to the rates currently available, it’s worth thinking about how best to prepare for the end of that deal.

We have no way of knowing what things might look like in two years, and while there is currently an expectation that interest rates will fall as inflation eases, there is little expectation of interest rates falling back to the historic lows that allowed you to lock in such a low rate.

It therefore makes sense to expect interest rates to still be higher when the existing deal ends. As a result, there’s even more reason to make the most of the current deal for the two years it’s left to run.

You clearly have a strong focus on reducing your mortgage as quickly as possible. With most fixed-rate deals, you’re tied to the deal during the fixed-rate period, and you’ll be charged a prepayment surcharge if you were to pay back the mortgage.

However, most lenders allow you to overpay up to a certain limit, usually up to 10 percent of the balance per year.

It pays to check your current balance and term. The monthly payments for a £158,000 mortgage at 1.78 per cent over 9 years would be £1,584 per month, so you may have paid off more than you expect – or the term could be slightly longer.

Nevertheless, your £200 monthly overpayments won’t be a problem with a 10 per cent allowance and so you have plenty of flexibility to increase that amount if you wish.

That said, it’s important to decide whether instant mortgage overpayments are the best course of action right now.

Rising interest rates are bad news for borrowers, but savings rates have risen. In some cases, this may mean that savings rates offer a higher interest rate than you pay on the mortgage.

That could mean that by making regular deposits into a savings account, you can build the overpayment fund you describe, while earning a better return than paying back the mortgage would get you.

> Find the best paying savings accounts on the This is Money rate tables

When making this comparison, do not forget to take into account whether you have to pay income tax on the savings interest.

The personal savings deduction has meant that many savers do not have to worry about paying tax on their interest, as the £1,000 for the base rate and £500 for higher rate taxpayers were sufficient.

Now that interest rates are higher, savings interest is more likely to become taxable and so overpaying, costliest first, is still worth considering.

Using the tax-free lump sum payment of your pension is another option to pay off the mortgage more quickly, but you should first consider all alternatives and seek expert pension advice.

It is important to understand how much you may owe at the end of the current deal and how much you have saved and/or overpaid.

We don’t know what the interest rate will be two years from now and what the potential growth of retirement savings will be relative to the reduction in mortgage rates using the surrender amount.

Crucially, you should consider how using the lump sum will affect your likely retirement income in retirement.

Paying off the mortgage earlier is a welcome reduction in expenses, but you should also be sure that you can generate enough income with a smaller residual pension pot, and also consider whether there might be other savings available or whether downsizing could be an alternative.

In the meantime, continue planning for the end of the current rate and how to lower the mortgage – but it’s important that you seek specialist retirement advice to understand any potential future tax considerations and any wider implications before deciding whether to use retirement savings.