Is paying your mortgage off quicker really the best option?

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.

 

Doing better

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.

 

Tax

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.

Five ways to benefit from record low interest rates

Interest rates have never been lower, and it’s possible they might fall even further. This creates opportunities for householders and businesses, so how can you best take advantage of low interest rates?

 

  1. Pay off your debt more quickly

By maintaining constant repayments as interest rates fall, you’ll reduce the time it takes to pay off your loan. That’s because interest will make up less of each repayment, with more going to reduce the outstanding capital. And the great thing is that to take advantage of this strategy you don’t need to do anything. Lenders usually maintain repayments after a drop in interest rates, unless you instruct them otherwise.

 

  1. Refinance your home loan

Lenders vary in the extent to which they pass on cuts in official interest rates. So if you want to reduce your loan repayments it might be worth shopping around to see if you can find a better deal from other lenders. Just make sure that, if switching lenders, you take all fees into account to be certain you really are saving money.

If you are restructuring your borrowing another thing to consider is fixing the interest rate on all or part of your loan. This can provide protection from the impact of rising interest rates in the future, though it may mean you benefit less from any further cuts in rates. However, with interest rates already very low, there is little  room for rates to fall much further.

 

  1. Buy a first home – or upgrade

Low interest rates create opportunities for first homebuyers to get a foothold/toehold in the property market, and for existing homeowners to upgrade to a bigger home or better location. While lower interest rates can be a bit of a two-edged sword, as they tend to drive up property prices, most people are happier borrowing in a low rate environment rather than when rates are high.

 

  1. Borrow to invest

While Australians love to invest in property, borrowing to invest in shares is also a viable wealth creation strategy. Often referred to as gearing, the key to successfully investing borrowed funds is that the total returns must exceed the total costs. As the most significant cost is usually the interest on the loan, low rates make this strategy more attractive.

Take care, however. Gearing can magnify investment returns, but it can also increase your losses. It’s therefore important that you fully understand investment risk and how to minimise it.

 

  1. Expand your business

The whole point of a reduction in interest rates is to stimulate the economy, and that includes encouraging business owners to invest in their enterprises. Low interest rates make it cheaper to borrow to buy equipment to increase productivity, to take on more staff, or buy out a competitor and generally expand the business.

 

Take advice

Some of these strategies are simple ‘no-brainers’. Others involve significant levels of risk. To take a closer look at how you can make the most of low interest rates, talk to your financial adviser.

Talk to us to find out more.