Not so long ago one of the most effective, low risk wealth creation strategies was to use spare savings to pay down a mortgage – either directly or via the use of an offset account. If your mortgage interest rate was 8% per annum (that’s the effective, after tax investment return) the strategy delivered, substantially reducing the term of the loan and delivering big savings on interest.
But what about now? With home loans being offered at interest rates of less than 4% pa, does using surplus savings to pay off the mortgage still make sense? Or is it better to contribute those savings to an investment that may provide higher returns? Let’s see what we can learn from Emma’s situation.
Emma is a 45-year old, single professional with a $200,000 mortgage on her home. The home loan interest rate is 3.4% pa, and Emma’s marginal tax rate is 39%, including the Medicare levy. Following a recent promotion, she has a savings capacity of $2,000 per month, plus annual bonuses. Her only other debt is $10,000 on her credit card with an interest rate of 20%. Emma has a healthy superannuation balance for her age and does not want to contribute more to super.
So, where to from here?
Although a relatively small amount in dollar terms, by virtue of its high interest rate the credit card debt should be cleared as soon as possible. The rules of managing high interest debt are simple: pay off the debt with the highest interest rate first and work down to the lowest interest rate debt. If possible, consolidate all debt at the lowest interest rate. In Emma’s case, if she can redraw some funds against her home loan, she should do so to pay off the credit card.
With the credit card completely paid off, Emma’s attention now turns to how to make the most of her savings ability. After looking around, she’s identified a number of investments that have consistently produced returns of more than 3.4% pa. Wouldn’t they be a better option than paying down the mortgage?
They may well be, but there are two important things that Emma needs to consider: tax and risk.
Extra payments made to the mortgage provide Emma with a net return, after tax, of 3.4%. But if Emma contributes her savings to a purely income paying investment, that income will be taxed at her marginal rate of 39%. To earn 3.4% after tax, Emma’s investments need to earn 5.57% pa before tax.
If Emma opts for investments that provide a mix of income and capital growth, such as shares and property, the tax situation becomes a bit more complicated. Tax on any capital gains isn’t paid until after the investments are sold, and if held for more than 12 months, Emma will benefit from the capital gains tax discount.
Even without these tax perks a targeted return of greater than 5.57% pa is one that Emma can realistically aim for, as long as she is comfortable with the risk.
Risk and return
A fundamental ‘law’ that investors can’t avoid is that higher returns come with higher risk which is more common with shares and managed funds. Paying off the mortgage is about as close to a risk-free return that Emma could achieve. However, in the current environment, Emma may well feel that pursuing the higher returns from an investment strategy is worth the greater risk.
What’s right for Emma isn’t necessarily right for everyone else. Age and stage of life, health and overall financial situation all influence the level of risk we may need or want to take on.
Is paying off the mortgage as quickly as possible the best option? It depends on your situation. And it doesn’t need to be all or nothing. A blend of paying down debt and investing may provide a happy median.
Got some spare savings capacity? Your Bridges financial planner can help you work out a wealth creation strategy that’s right for you.