I received a pension lump sum – should I pay off my £117,000 buy-to-let mortgage?

I bought a buy-to-let in 2007 with a 25-year interest-only mortgage, which now has just over seven years left.

The mortgage balance is now £117,000. It currently has a variable interest rate, but I am considering locking it in for two years with the same bank to reduce my monthly payments, as I think it will take time for interest rates to come down.

But I recently retired and received a lump sum from my pension. I am thinking of selling the property in 2032 upon completion of the mortgage.

Instead of remortgaging, should you consider using part of the lump sum to pay off the property now?

The alternative is to keep the lump sum and pay off the mortgage by selling the property in seven years, when the mortgage term ends.

If I did that, would I pay less capital gains taxes, because I would be paying a portion of the value of the property to the mortgage lender and not benefit from it?

Ed Magnus from This is Money responds: Although you purchased just this property before the 2008 housing crisis, hopefully your rental property has proven to be a good long-term investment.

There is a sizeable interest-only mortgage on the property, which you say has a variable interest rate.

While current forecasts suggest the Bank of England will cut interest rates from 4.75 percent to 4 percent or 3.75 percent by the end of this year, there is no guarantee that will happen.

Forecasts are often wrong. At the beginning of 2024, markets were predicting that the central bank would cut interest rates six times throughout the year. In the end there were only two, with rates falling from 5.25 percent to 4.75 percent.

Currently, the two-year average rate for 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 type of property, and the level of equity you have in the property, you may be able to get much better results than the average rate.

The cheapest two-year fixed-rate buy-to-let mortgages with some of the big banks are under 5 per cent.

For example, Virgin Money charges 4.54 for a two-year arrangement with a 1 per cent origination fee. On her £117,000 mortgage that would mean paying £443 a month with interest alone.

It would be worth speaking to a mortgage broker to assess your options.

Paying off part of your 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 will not change whether you pay off the mortgage through a lump sum or by selling the property.

For expert advice, we spoke to Karen NoyeQuilter mortgage expert and Elena Todorovadirector of the mortgage brokerage SPF Private Clients.

What are the capital gains tax rules?

Elena Todorova answers: Surprisingly, the amount of capital gains tax is not tied to the amount of debt you have 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 doesn’t matter if you have a mortgage to pay at the time of sale.

HM Revenue and Customs is interested in the increase in the value of the asset and not whether there are obligations associated with it.

You also cannot deduct money spent on routine property repairs and maintenance.

Should they pay the mortgage with the lump sum of their pension?

Karen Noye responds: If you use your pension lump sum to pay off part or all of your mortgage, it will not directly affect the way CGT is calculated.

You are correct that predictions indicate that interest rates are likely to fall 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, as of 2020, landlords can no longer deduct mortgage interest from rental income.

Instead, you get a 20 percent tax credit on your mortgage interest, which can affect your finances.

Using your pension to pay down your mortgage could reduce your monthly costs, but it’s crucial to consider how this could affect your retirement plans and quality of life as you age.

Elena Todorova adds: Regarding 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 smaller the tax credit and the more taxes you will pay on rental income.

You also have to consider the alternative cost. Would it be better to leave your pension funds where they can grow in a tax-beneficial environment and generate a higher pension return?

Or reduce your pension, which will give you a lower monthly income but allow you to save a certain amount on the interest rate?

Withdrawing pension money will have a long-term impact on your pension and making payments now will result in an immediate reduction in the mortgage you are paying.

Before making a final decision, I would recommend speaking to a tax advisor, a financial advisor, and of course a mortgage broker.

Should they set their variable mortgage rate?

Karen Noye responds: If you decide to stay with the mortgage and not pay it off, switching to a fixed rate will give you more predictable payments and could save you money in the short term.

If you took a two-year solution, you would have the option to re-evaluate when rates might be lower.