‘Should I use £110k windfall to pay off mortgage?’

This reader is wondering if she should invest some of her lump sum. Sam Brodbeck seeks expert advice

Persistently low mortgage rates have distorted financial planning for the best part of a decade. Despite the expectation that the Bank of England will raise Bank Rate next month, fixed-rate home loans remain historically cheap. The best twoyear fix at the moment, with a 40pc deposit, costs just 1.29pc.

With the cost of borrowing so low, consumers’ behaviour has changed. Many have borrowed more, while others have delayed paying off debt in favour of investing spare cash elsewhere.

Carol Smith, 55, is faced with this very dilemma. After 28 years working in various roles at the Metropolitan Police, Ms Smith is considering retirement. The police pension scheme, like others in the public sector, was made less generous in 2015. While still “defined benefit”, the plans changed from paying income based on almost-final salaries (which were almost always higher) to a career-average salary.

Luckily for Ms Smith, the changes did not affect anyone within a decade of retirement. That means her income will be based on her final salary and – because she has more than 25 years’ service – she can retire immediately if she wishes.

The pension will pay a lump sum of £110,000 and then a monthly posttax income of £1,250. Ms Smith also has a £10,000 stocks and shares Isa with Invesco Perpetual, but no other savings. She has an outstanding mortgage of £119,000 on her £490,000 Buckinghamshire house and is otherwise debt-free.

Paying off the mortgage with the lump sum and Isa money would be the most simple solution, but is it the best one?

Not taking the lump sum of cash would boost her police pension, which will need to tide her over until she starts to receive the state pension a decade or more later. “I’m not willing to leave my mortgage untouched as the £900-a-month payments are too high,” she said. “But should I pay my mortgage off entirely or part-pay to reduce the monthly payments and invest the rest? I don’t want to take big risks as the money will be needed to pay off the mortgage at some point.”

The fixed-rate 2.99pc mortgage expires in November next year and Ms Smith is keen to make a decision before then. She lives with her daughter and has a lodger, who pays £650 a month rent. Ms Smith should use the vast majority of her lump sum to repay her mortgage. Any investment would have to produce more than 2.99pc a year after tax to be more beneficial. This cannot be guaranteed. Given that mortgage repayment is a risk-free option, this has to be a sensible use of the money.

Moreover, interest rates are only going in one direction: up. In addition, the cost of the mortgage may well increase at renewal.

That said, Ms Smith should consider holding some money back for an emergency fund. Having to take out short-term borrowing quickly can be very expensive and Ms Smith would be kicking herself if she either had to take money out of the Isa at a low point in the market or put large sums on a credit card. Holding back about £10,000 should be sufficient, leaving £100,000 to repay the mortgage debt. Ms Smith should place the remaining £10,000 in NS&I’s Direct Saver, which pays 0.95pc a year with instant access.

Ms Smith needs to review the terms and conditions of her mortgage to see when it is cost-effective to repay capital. The mortgage may allow a certain amount of overpayment each year without penalty. Otherwise there are usually early repayment charges, which vary between providers.

She should simply calculate how much interest she would pay on the mortgage until November 2019 and take away the net interest she would earn on the £100,000 over the same period. She should then compare this with the early repayment penalty.

In relation to the £10,000 Isa invested with Invesco, whether it is appropriate or not would depend on her investment mix. We would recommend considering an Isa with Standard Life. Ms Smith might want to look into using the MyFolio Market III fund. This fund aims to generate a total return from a combination of income and capital growth over the longer term. It solely invests in “passive” funds that have been well researched by a large team at Standard Life. The Standard Life fund itself is actively managed.

The passive portfolio construction of the fund means that the overall cost of the underlying holdings is lower, which would suit someone with a smaller sum to invest. As it’s designed for an investor with a balanced attitude to risk (who isn’t necessarily seeking risky investments but isn’t avoiding them either) it would suit someone who is looking to invest for the longer term, such as Ms Smith.

Her rental income will need to be declared via self-assessment and there are two different ways it can be taxed. The good news is that the tax should be minimal.

When Ms Smith is completing her tax return she should elect for “rent-a-room relief ”. This means the first £7,500 of rental income is tax free; any excess will be taxed at her marginal income tax rate. If in any year Ms Smith spends more than £7,800 in expenses on the room, it may be more tax-efficient to be taxed in that year on a “profits basis”, as no tax would be due. If you’d like to be considered, please email, with the header “Give me a Money Makeover”, to money@ telegraph.co.uk and provide the following information:

Your name, age and telephone number (we will not share this with anyone)

Your main financial goals (as much detail as possible, please), details of any debts (including mortgages) and how you would describe your attitude to any investment risk

Your current investments, including cash and property

You must be willing to be photographed for the article. The most important question is whether or not Ms Smith can actually afford to retire even with her excellent police pension.

Previously the state pension age was 60 for women and 65 for men but many people are still unaware that the Government has been increasing this, on a phased basis, to 68 for both sexes.

As Ms Smith is 55 her state pension age will be 67. This seven-year delay in receiving her pension might affect her retirement planning if she has not already taken this into account.

She should obtain a projection of her state pension as if she stops work now her National Insurance contribution history may be insufficient to qualify for the full amount, which is currently about £165 a week.

Most people would feel better being debt-free and it is normally best to use your savings to repay outstanding debt. This is because the interest rate charged on debt is normally more than that paid on savings. Using the lump sum to reduce or repay Ms Smith’s mortgage would also reduce her monthly outgoings, which could make retirement much more viable.

However, Ms Smith has a fixedrate mortgage and these normally carry an early redemption penalty. Consequently, it’s important that she checks with her mortgage lender before taking any action either way as the penalty may make sitting tight the best option.

Bizarrely, at the moment some savings accounts are paying higher rates of interest than some mortgages are charging. If this

‘Should I pay my mortgage off entirely or part-pay to reduce the repayments?’ ‘It may be possible to save money by placing the lump sum on deposit’

remains the case it may actually be possible for Ms Smith to save money by rearranging her current mortgage on to a better deal and simply placing the tax-free lump sum on deposit, although this does carry additional risks and won’t reduce her monthly outgoings.

If an early redemption penalty outweighs the benefit of repaying the mortgage early I’d suggest that Ms Smith keep any tax-free lump sum on deposit until her fixed-rate mortgage ends in November 2019. She then can review her options.

Given the above timescale, Ms Smith should look at an 18-month fixed-term deposit account. Some Islamic and digital banks are currently offering competitive rates of up to 2pc. Given the amount involved, it’s important that she splits the lump sum between at least two banks to ensure that she benefits from the full £85,000 Financial Services Compensation Scheme protection for depositors.

As Ms Smith is receiving £650 a month rent she will need to declare this on her tax return as it is more than the £7,500-a-year tax-free allowance.