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Do you cash in your pension to settle your mortgage?

5 min read

Around the age of 35 most people who change jobs will cash in their pension fund to settle their mortgage. So I decided to crunch the numbers to see if it makes financial sense. The results are quite astounding.

My assumption is a 25-year-old professional earning R20 000 a month who saves 11% of their before-tax salary into the company pension fund (this is the average percentage employees save according to a retirement survey by Sanlam).

For simplicity I have assumed no salary increases.

Scenario one:
In this scenario you buy a home at the age of 30 and cash in your pension at the age of 35 to settle the mortgage.

  • The initial mortgage is R600 000 with repayments of R5 400, by the time you turn 35 you have R550 000 outstanding on your mortgage

  • Assuming your pension grows at 11% a year, at age 35 you will have accumulated R480 000

  • When cashing it in you pay R100 000 in tax and therefore have R380 000 left to pay into your mortgage

  • Your mortgage is R170&nbsp000 and you continue to pay off your mortgage at the same rate (R5 400) and fully settle your mortgage at the age of 39.

  • You continue to contribute 11% of your salary to a pension fund until the age of 39 when your mortgage is repaid and then you increase it to the maximum tax-free allowance of 22.5% (R4 500 per month).

  • You save an additional R3 100 into unit trusts in order to match your savings with your previous mortgage payments

  • Pension fund: Assuming a 11% return per annum, at the age of 65 your pension fund will be worth around R10-million (before you get excited this is does not take inflation into account, so this is not what R10-million is worth today)

  • Unit Trusts: Assuming an 11% return you would have saved R5.4 million. You would pay R440 000 in capital gains tax leaving you with around R5 million.

    • You are debt free at the age of 39 and your total savings are worth R15-million. You will not receive a tax-free lump sum on retirement as you have cashed in your funds.

    Scenario two:
    In this scenario you buy a home at age 30 and pay it off over 20 years leaving your pension intact

    • You pay 11% of your salary (R2 200) into your pension until the age of 50 when your home is paid off

  • At 50 years old, bond-free, you increase your pension saving to the maximum tax-free allowance of 22.5% of salary (R4 500)

  • You save the additional R3 100 into unit trusts to match your savings to your previous mortgage repayments

  • Pension fund: Assuming a growth rate of 11% your pension would be worth R20-million at age 65

  • Unit trusts: Assuming a growth rate of 11% you would have saved around R1.4-million. You would pay R84 000 in capital gains tax leaving you R1.3-million

    • You are debt free at the age of 50 and you have total lump sum of R21.3-million. You will receive a tax-free lump sum withdrawal of R300 000 from your pension.

    Conclusion
    These numbers speak for themselves. These figures are simplistic and one is making assumptions about the relative percentage of the mortgage rate (9%) vs growth rate (11%).

    However one can reason that if the mortgage rate increases substantially it would be due to inflation so therefore market returns would rise accordingly.

    The differential of 2% is probably realistic over a period of time. The larger the difference between the mortgage rate and the market rate the more it favours the pension fund saving.

    The two factors that really influence these numbers are the lump sum and the tax: The R500 000 lump sum left to grow at 11% contributes R13-million to the final lump sum.

    The R100 000 paid in tax reduces the final lump sum by R2.6-million.

    Dealing with the human factor
    Realistically most people will upgrade their homes at some stage and if they have settled their mortgage they will use the additional cash-flow to buy a larger home rather than replacing their retirement fund. In that case, the figures move even more in favour of not cashing in.

    The argument could be that you downsize in retirement, however the cost of smaller homes can actually be higher especially in a secure complex, so this is never a good strategy.

    Generally we tend to focus more on paying our debts than on saving, so if we have “forced” savings that we never touch we are likely to make lifestyle adjustments to meet our borrowing needs.

    In other words if you want a bigger home you will find ways to manage that on your budget by cutting back elsewhere. We just don’t have the same motivation if we are trying to increase savings, probably because there is not the threat of losing our home.

    In the real world the best strategy is to adjust your savings and borrowing over time as your life changes.

    • Save as much as possible from the age of 25 to 30 so that you have a significant deposit for the same priced home.

  • Maximize your retirement savings (at 15% at least) until you start a family and buy a bigger home seven years later (this is the average turnover of new homes), then cut back retirement savings during those crunch years.

  • Use bonuses and salary increases to make sure your home is paid off by the time you are 50 and then maximize your retirement savings (22.5% of salary) until age 65.

    • This will at least provide you with a decent retirement without cutting into your lifestyle.

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