Should you pay down your mortgage faster or keep investing?
As the cost of borrowing rises, a question I am increasingly asked is whether it makes sense to start funnelling more surplus cash flow towards paying down your mortgage, as opposed to continuing to put that same amount of cash into shares or other investments.
The average interest rate being paid on all outstanding variable rate home loans is now nudging 6 per cent, so the potential savings from debt reduction are increasingly attractive.
As the cost of borrowing rises, a question I am often asked is if it makes sense to pay down your mortgage or invest your excess cash.Credit:Dionne Gain
The first thing to note is that if you are grappling with this question, it is actually a lovely problem to have. It means you are managing to save some proportion of your income after expenses – and in today’s environment of rising costs, that is no mean feat. So, keep up the great work.
And significant spoiler alert: like so many things when it comes to money and investing, there is actually no clear-cut, one-size-fits-all answer for everyone. So, you can relieve yourself right now of the burden of thinking there is.
However, it is true there are better or worse strategies to pursue here, depending on your personal circumstances, risk tolerance, proximity to retirement and existing cash buffers. So read on.
First, let’s consider the pros of paying off the mortgage faster.
Any dollar you throw back at your lender to reduce your total debt owing reduces the dollar amount of interest you will pay not only this year, but every future year in which you would have otherwise carried that debt.
Of course, how much that total saving turns out to be over time depends not only on this year’s interest rate, but next year’s, and the year after and so on. Rates may be 6 per cent now, but they could fall again, to say 2 or 3 per cent, reducing your cumulative saving from mortgage reduction. Alternatively, of course, they could go up and stay higher, increasing the benefit of mortgage pay down over time.
Any interest saved this way must be compared to the after-tax return you could expect to get from investing the same dollar. Of course, investing comes in many forms and can be structured to involve leverage. But for this article, I’ll just focus on buying shares outright.
Returns on shares, as we all know, can vary wildly from year to year. Even on broad-based index-tracking shares, years of negative returns are not uncommon. However, over the longer term, shares as a whole have tended to attract a ‘risk premium’ that justifies holding them over safer assets like cash or fixed interest.
Investing works best if you don’t try to time the market and simply purchase in regular increments.
When income produced from shares via dividends is reinvested, this can be a powerful wealth creator via the impact of compounding returns.
Of course, tax is a major factor to consider here. And I don’t just mean taxes on investment returns (which are significant and I’ll get to) but also the tax applied to your income when you decide to either take it as take-home pay or direct it to investments via your super.
Higher-income earners lose between 37 and 45 per cent (plus the 2 per cent Medicare Levy) from every dollar they choose to take as take-home pay to throw at the mortgage or invest outside of super.
By contrast, investing pre-tax dollars into super, rather than taking them as take-home pay, attracts the lower tax rate of 15 per cent (up to an income of $250,000 where a higher tax rate applies).
If you don’t mind not seeing your money again until you’re in your sixties, maximising the amount of money you invest into super, up to the $27,500 annual concessional cap, can be a very effective wealth-building strategy, particularly for mid to high-income earners. From the get go, you get keep 85 per cent of your earned income, as opposed to just 61 or 53 per cent, which greatly expands your investible income.
If you expect to still be paying your mortgage when you reach your super access age, you can use a lump sum from your super to pay off the mortgage. Something to keep in mind.
When you make investments outside of super from your post-income tax income, such as into shares or investment properties, you will, of course, have half of any resulting capital gains taxed at your full marginal rate, reducing the after-tax returns from investing.
This means that to enjoy the same after-tax return on your money as you’d get from paying off your home loan faster, you need to earn a higher percentage rate of return than the average prevailing interest rate you’d otherwise pay.
Still, investment returns of above 6 per cent (including dividends and capital gains) are not uncommon over the longer run.
At the end of the day, you must consider what is right for you and seek advice as needed. If choosing to pay off a bit more of your mortgage would help you sleep better at night, then that can be a solid strategy.
As a rule, however, I am cautious about making whipsaw changes to your long-term investment and leverage strategies based on short-term swings in either interest rates or asset market valuations.
No one knows where interest rates will be one year from now; just as no one knows where the share market or property market will be. Investing works best if you don’t try to time the market and simply purchase in regular increments.
If you really can’t decide, one final strategy to consider is what I call the ‘porque no los dos’ (why not both) strategy of splitting your savings into a combination of both making extra mortgage payments and also continuing to invest, either inside or outside of super.
Both can be great strategies to consider as part of your own individual financial plan.
Essentially, you’re grappling with a choice between two great outcomes: either paying off your mortgage faster and getting that much closer to being able to live housing-cost-free in retirement (one of the best strategies for a comfortable retirement there is) or, alternatively, continuing to expand your ownership of either income-producing or capital appreciating (or both) assets which will turbocharge your wealth over the long run.
As I said, a nice problem to have.
- Advice given in this article is general in nature and is not intended to influence readers’ decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.
Jessica Irvine is author of Money with Jess: Your Ultimate Guide to Household Budgeting. You can follow more of Jess’ money adventures on Instagram @moneywithjess and sign up to receive her weekly email newsletter.
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