To pay or not to pay? That is the mortgage question.
Home ownership is the Australian dream, but we also have a lot of other big dreams…overseas holidays, buying a boat or sending the kids to a great private school. So how do you decide whether you should pay off your mortgage faster or invest it for your big dreams?
The debate on paying off your mortgage versus investing can seem never-ending, and everyone has an opinion. When it comes down to it, the right course of action depends on your personal situation, risk profile and financial goals.
One way to evaluate the situation is to think mathematically– you can compare the tax implications, interest savings, rates of return and past market movements.
This sort of evaluation can be complicated, so it might be best to get your financial adviser involved to help with the quantitative analysis. Before you do that, you can ask yourself a few questions to start the decision making process.
How many years do you have left on your mortgage?
If you have less than 10 years left on your mortgage, you might want to consider paying it off, as 10 years may represent a short period to invest in the stock market or investment bonds.
How good are you at sticking to a plan?
Paying off your mortgage early may present you with a surplus of cash or disposable income. If you are not disciplined and stick to your investment plan, you may find yourself tempted to spend your surplus funds. This can set you up in a fantastic lifestyle, but it may not be sustainable through your retirement if you don’t save enough.
Is your lifestyle stable?
You know your personal situation best and you can decide how stable the future is likely to be or if there is a high probability that something will come along and derail your financial plans. If you feel secure in your job and that you won’t need to access a lot of cash quickly, then aggressively reducing the mortgage might be the best path for you.
If you are the sole bread winner or job security is an issue, you might look at investing so that you can access your money in case of emergency or leaving the surplus within a redraw facility.
If your mortgage does not have a redraw facility and you pay it off aggressively, you could run the risk of needing to borrow money later at a higher interest rate.
What are your investment goals?
If you need to invest for an important goal, you need to look at how much money you will need for that goal and how far off it is. If your goals are a long way off, you can have the satisfaction of both investing and making additional payments on your mortgage. It is as simple as allocating part of your available surplus funds for one goal and then using the remainder towards reducing your mortgage. When it comes to your mortgage, even small payments can make a difference over the long term.
So, what should you do?
You need to look at both the mathematical and emotional parts of your financial strategy. Your financial adviser will help you weigh the pros and cons of different investments and can provide a financial analysis for each option.
Remember that no matter which direction you choose, you can always re-prioritise later to keep up-to-date with your changing circumstances and market conditions.
Judith has a home loan of $250,000 with 20 years left to pay.
She is paying $1,908.35 per month of principal and interest and has an extra $100 a month to play with. She is considering the following options:
|Option||Implication after 20 years
|Use the $100 to pay off her mortgage, after she has paid off the mortgage after the 18th year, she will have $2,008.35 a month in cash which she will invest||Judith will have $51,780 in her investment|
|Invest the $100 into an investment bond||Judith will have $43,888 in her investment|
|Invest the $100 as a contribution to super after tax||Judith will have an additional $46,655 in her super|
|Salary sacrifice the amount as $194.17 before tax||Judith will have an additional $77,001 in her super|
Things Judith will need to consider:
- The best option is for Judith to put her extra money into super via pre-tax salary sacrifice payments, however these contributions are preserved (locked away) until retirement and Judith may need to access this money before she retires.
- If she pays off her mortgage, she will then need to look at her ability to redraw the money if she needs to access funds in the case of an emergency.
- If she invests into the share market, she will have to pay tax on the investment earnings and capital gains upon sale of the investments.
- If she pays the $100 into an investment bond, the investment earnings (including capital gains) will be taxed at a maximum rate of 30%. Withdrawing from the bond after 10 years from the initial investment means there will be no taxation implications.
- The calculations in this case study are based on the following; the mortgage has 6.8% interest rate, her super fund, investment bond and investment portfolio returned 6.5% (inclusive of 3% pa growth, net of fees and excluding franking credits). Tax on earnings has been factored into all options (including the super fund and investment bond) whilst she paying 45% tax (not including the Flood Levy) on the investment portfolio. But these could change in the future.
David Hasib – Director, Chan & Naylor Wealth Planning
Disclaimer: This article contains general information; before you make any financial or investment decision you should seek professional advice to take into account your individual objectives, financial situation and individual needs. Click for more detail regarding this disclaimer.