Puzzle Finance Blog
Should you pay off the mortgage or invest elsewhere?
Homeowners who are more focused on their own mortgage than how the next generation will get into the property market face an interesting choice once they’re seven to 10 years into their home loan.
By that stage they’re usually earning more and have extra funds to either power down the biggest loan they’re ever likely to have, or start building other assets.
Advisers argue there are two good reasons to pay off your mortgage.
The first is it’s a non-deductible debt, meaning you don’t get a tax deduction on the interest because it’s not for income-producing purposes as it is on an investment loan.
The second is, by getting rid of the debt, you’re in effect getting a return equivalent to your loan’s interest rate. Even better, it’s tax-free because you’re not actually earning it but saving yourself from paying it.
Using the same amount to invest would mean you’d have to get an even higher return to justify doing this over using the funds to pay off your loan.
Let’s look at someone paying the top tax rate of 45 per cent (not including the Medicare levy) who is paying 5 per cent on their mortgage. The return they’d need from another investment to better the after-tax savings of repaying the mortgage would have to be at least 9.1 per cent. For someone on the next tax bracket of 37 per cent, the required return would be 7.9 per cent.
Advisers such as Mike Ingham of Godfrey Pembroke say this is a rule of thumb only because it doesn’t take into account potential capital gains. You can work out the required return yourself, based on your own tax and mortgage rates, by following these steps: subtract your tax rate from 100, divide your loan interest rate by this figure, then multiply by 100.
Whether or not you choose to use all your extra cash to pay off your home loan, it’s vital to set an “end date” and to know exactly how much extra interest you’re up for by languishing with the standard 25-year loan.
Take a $600,000 mortgage with a 5 per cent interest rate. According to Commonwealth Bank’s home loan calculator, the monthly repayment would be $3508.
Let’s look at the small print behind this. What you’re actually committing yourself to is paying a total of $1,052,113 over 25 years. You’re not just repaying the $600,000, you’re also paying $452,113 in interest.
But what if you could pay an extra $1000 a month? Changing your monthly repayment to $4508 would cut your loan time to 16 years and three months. Your total payout would be $876,779, meaning interest of only $276,779 – a saving of $175,334.
While these are powerful persuasions, remember that compound interest has the opposite effect on investments: the longer you’re in them, the more time they have to accumulate. Let’s use, as an example, a couple we’ll call Mark and Amanda. Mark is 41, earns $150,000 a year and has $150,000 in super. Amanda is 38, earns $120,000 and has $90,000 in super.
One of the couple’s biggest expenses is childcare, which costs them about $3200 a month. Their twin sons are about to start primary school, and they’re debating what to do with the money they will save on childcare.
Working off the MoneySmart retirement calculator set up by the Australian Securities and Investments Commission, if they both retire at 61 their combined retirement income will be about $57,000 a year (in future dollars) assuming they continue making no pre-tax or salary-sacrifice contributions to super, but rely on compulsory super.
But if they salary-sacrifice $24,000 a year into super ($11,000 for him and $13,000 for her so they don’t exceed the $25,000 annual contribution caps), this will boost their annual retirement income to almost $76,000. That still leaves $14,400 a year from the savings on childcare.
Say the couple has the $600,000 loan mentioned previously, paying the extra $1200 a month will pay off their loan in 15 years and three months and cut their interest bill to $257,329. The overall interest saving by paying it off 10 years early will be almost $195,000, a welcome boost to any wealth creation plan inside or outside super. So there’s a good argument for paying off your home loan early and investing at the same time.
For most people, the latter will be into super, unless they are already close to breaching super caps.
Equity Trustees adviser George Bourbouras has a good adage: put away 20 per cent of your gross income every year into retirement savings. It will not only boost your nest egg but “condition” you for retirement where you won’t be able to live beyond your means.
Posted by Debra Cleveland - Australian Financial Review on 13th January, 2014 | Comments | Trackbacks
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