Using a Lump Sum to Pay off a Mortgage

One question that often pops up in the CII R06 and AF5 exams is the consideration of whether it’s better to invest a lump sum, such as a recently received inheritance, or to use it to repay an outstanding mortgage. In this blog post, we consider the pros and cons of each.

This article is correct as at 17 October 2023.

Potential benefits of paying down debt

Being debt-free is a goal many of us would love to achieve. Depending on a client’s individual set of circumstances, the benefits of repaying a mortgage in full (or indeed in part) may include some or all of the following:

• A reduction in debt; due to the mortgage being repaid.
• An increase in peace of mind; as there is no need to worry about ensuring there is an ongoing income to meet monthly repayments.
• A reduction in the amount of investment risk the client is exposed to, as the capital is used to pay down the debt rather than being invested in shares, for example.
• A reduction in the overall interest payable; as no further interest is due if the capital is repaid in full or, if repaid in part, then interest is payable on a smaller amount of capital and will therefore be less.
• An increase in disposal income as there will be no (or reduced) monthly mortgage repayments; this increases affordability in general and, specifically, for other financial objectives the client might have.
• An improvement in the client’s credit rating; this may be helpful in the future.
• No early repayment charges (potentially, depending on their contract). 

Potential downsides of paying down debt

We’ve already mentioned early repayment charges. So, while there’s a potential benefit of no charges for some, those on a fixed deal, for example, may be faced with a charge. Where this is the case, we need to get the calculators out to determine how much of a downside this is and whether waiting until after the deal has expired makes more sense financially. Further potential downsides include:

• A reduction in liquidity; once the funds have been used to repay the mortgage they cannot, for example, be used in an emergency.
• A loss of the future income and growth the client could have achieved had they invested their lump sum.
• In a similar vein, missing out using tax allowances and/or tax relief that would have been available had the client used the lump sum to fund ISA or pension contributions.
• Finally, for those with a more adventurous attitude to risk, paying down debt may not be in line with this as it is, effectively, a risk-free option

Investing a lump sum

Investing a lump sum may enable clients to reach their future goals sooner, especially where the money is invested in a pension meaning the contribution is boosted by tax relief.

However, in addition to the drawbacks of overpaying the mortgage, investing a lump sum has further potential downsides including:

• Risk of capital loss; the lump sum will be exposed to investment risk and could be lost.
• Market timing risk; investing a lump sum prior to a stock market crash can result in an immediate loss, albeit only on paper assuming the investment is for the long term. In addition, there’s no way of benefiting from pound cost averaging.
• Generating taxable income or gains for the client if the amount available to invest exceeds their available ISA and pension contribution allowances.
• Requires action; investing a lump sum takes time and requires the investor to take action. For those with busy lives or who are prone to procrastination, finding the time to make the investment may be an issue.
• Changing priorities; where a lump sum is available, there may well be competing priorities for its use. Generally, people tend to put off investing for the future and focus on more immediate goals such as holidays and home improvements.

Arguably, what matters most is that the client is comfortable with their decision. Both methods have pros and cons of which clients should be aware so that they can make an informed choice on the best route for them.

Grab the resources you need!

If you’re studying for your CII R06 exam, and you want to feel more confident on exam day, grab our free taster analysis to try out one of Brand Financial Training’s resources for yourself.  Click the link to download the R06 case study analysis taster now!

Alternatively, you can download a taster for AF5 if you are preparing for that exam.