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.

Why business owners need to look after No. 1

By Daniel Irving

When owning and running a business, efforts to future-proof your own financial wellbeing most often rates lowly on the priority list.

In my experience, business owners consistently do three things that don’t work in their favour and in doing so neglect their own personal finances and future financial wellbeing.

Seeking professional advice is an important investment in your future. It’s important to do your research and find a professional that has a proven track record and experience in working with small business owners.

  1. Fail to put money aside for the future (in assets that will grow and benefit themselves later in life)

The perfect example is superannuation. Business owners will often say that they don’t have superannuation, or they don’t have to contribute to super because they are self-employed. A common belief amongst business owners is that “the business” is their superannuation or retirement savings.

That strategy works well if your business is consistently growing in value or will likely have an attractive value in the future that somebody is prepared to pay for. After all, that’s the reason why you are building your business and not investing your cash, profits or dividends into other assets along the way, right?

The problem is that some businesses don’t grow in value. Many businesses will be sold for much less than the purchase price, some change hands for the equivalent of no more than 12 months of wages of the selling business owner. Others will be sold for just the value of the stock in the warehouse, workshop or shop floor.

Plenty sell for well under market price because the business owner simply had no idea what the business was worth. Many will exchange for fire sale prices because the business owner rushed the sale process because they didn’t manage the succession process properly. More on this shortly.

Lastly, many business owners will just wait until the lease expires, turn the lights off, close the door behind them and cease trading, realising no value whatsoever for all the hard slog of building their business.

  1. Not understanding the valuation of their business

Business owners often have specialist knowledge or skills in a particular field or industry. Understanding how to calculate value, how it is determined, how it can be improved and the factors that affect valuation are considerations that are not front of mind.

Importantly, not all businesses or business models have large, growing or even any value at all. The quicker business owners understand and realise this, they will understand they have the choice of improving or changing their business model.

They may choose to simply squirrel away as much cash as they can from the business while they continue to trade and use that cash to invest in other assets or business’ that will grow and/or provide them with a future income stream to replace the business the day their business stops trading.

If many more business owners understood what the future may likely hold for them, they’ll make much better decisions today for their own financial well-being.

  1. Plan their own business succession poorly

Business owners will often leave their exit plan to the last minute or eleventh hour, preferring not to think about the reality that they will eventually leave the business whether by choice, disability, death or another reason. The result inevitably is a negative impact on the valuation of the business. It also stands to negatively affect employees, clients of the business and the owners’ family.

For any business owner, if you haven’t worked alongside specialists in succession planning, you are putting everything you have worked hard for in establishing the business at risk. A detailed succession plan can determine whether your business thrives and grows with minimal disruption or becomes overrun with disputes and confusion or a lack of vision as to how to move forward.

Without a solid succession plan developed in consultation with family, management, an estate planning lawyer, and other professionals, you are setting the business up for one, or all, of the following:

  • The value of the business may be lessened when survivors choose to sell it.
  • The entire business will be adversely affected by power struggles and chaos, and the culture will reel from negative emotional impact.
  • Clients will lose faith in the ability of the business to continue to serve them at the level expected.
  • Employees will seek other opportunities in lieu of perhaps clinging to a sinking ship.  the business fails because the owner kept much of his knowledge to himself.

In my experience, this cautionary tale is relevant to nearly all business owners. They all present with the same symptoms, but all have a different haircut and business card. For the sake of a secure financial future it is vital business owners look after their most important resource: themselves.

First published on Hunter Headline

Bridges Financial Services Pty Limited (Bridges). ABN 60 003 474 977. ASX Participant. AFSL No 240837. This is general advice only and does not take into account your objectives, financial situation and needs. Before acting on this advice, you should consult a financial planner.

We need to protect our most valuable asset

We need to keep our biggest assets safe, so what’s yours?

If you own a home, you might be quick to think of it. Or maybe you think your most valuable possession is a pricey car or a material possession that you spent a lot of money on. However, any of these guesses would be incorrect.

Your biggest asset, the one that allows you to afford all other purchases throughout your life, is your income.

How would you and your family cope if you stopped earning a wage? Would you still be able to pay your everyday bills and expenses? Let alone any big holiday or education costs you may be faced with?

Your income is certainly your most valuable asset, so you need to keep it safe. How? Insurance!

House, car and life insurance are the obvious ones, and are three investments that we recommend you take out. You may also elect to use a form of insurance on your mortgage.

However, it’s very important to ensure you are covered in the event of illness or injury and unable to work for a significant period of time as a result.

Most income protection insurance contracts will provide you with a monthly payment of up to 75% of your standard income while you’re not working. By taking out this coverage, you can rest easy knowing you and your family can still get by in the case of an accident.

If you don’t insure your biggest asset, you run the risk of having no income if you fall ill or get injured. Not only does this mean you’d be unable to make ends meet day to day, but you would also be unlikely to afford the (sometimes pricey) medical and rehabilitation fees that are part and parcel of experiencing an accident.

To talk about your assets, or your insurance needs, get in touch with us today and we can help put you on the right track. Our friendly and professional staff can help you gain peace of mind when it comes to protecting your income.

Bridges Financial Services Pty Limited (Bridges). ABN 60 003 474 977. ASX Participant. AFSL No 240837. This is general advice only and does not take into account your objectives, financial situation and needs. Before acting on this advice, you should consult a financial planner.