Invest, pay off mortgage or make extra super contributions?
One of the most common questions I get asked as financial advisor is “now that I’ve got some spare cash should I pay off my home loan, invest or make extra super contributions?” So in this article, I will show you how to prioritise these three essential activities.
Of course, the first step is to get your financial house in order. If you can’t answer yes to all three of these questions, you should focus on paying down your debts (other than your home, car and HECS) and building an emergency stash first.
- Do you spend less than you earn, every paycheque?
- Have you paid off all of your debts (except your car, mortgage and HECS)?
- Do you have an emergency stash of at least three month’s spending?
Restating the problem
I’ve got some spare cash, should I pay down my mortgage, invest or make additional super contributions?
The right answer boils down to a trade-off between, lifetime return, certainty and flexibility. So the answer is “it depends”.
So how do you decide?
I'll use the example of someone with a $400,000 home loan at 5.64%, has $10,000 saved and can commit to saving $500 a month and compare the outcome for three scenarios over ten years. I chose 5.64% because it is the average variable rate home loan over the past 20 years.
- Scenario #1: Kate uses the savings to make an immediate principal repayment with the $10,000 and additional monthly repayments of $500 on their home loan.
- Scenario #2: Chris invests the $10,000 in a diversified portfolio and makes additional investments in the same portfolio every month.
- Scenario #3: Sarah makes a tax-deductible contribution of $10,000 to her super and then makes monthly salary sacrifice contributions which reduce her take-home pay by $500 a month.
I have assumed that all of them earn between $45,000 and $120,000 a year and so pay tax at 32.5% (plus the Medicare levy of 2%).
Make Extra mortgage payments
Scenario #1 is the simplest to set up. All you have to do is deposit the cash in your home loan account. Kate makes an immediate payment of $10,000, reducing her home loan straight away by $10,000 to $390,000. This saves her interest every month so that more of her regular payment goes to paying off principal and allowing her to pay off her loan faster.
She then sets up an automated payment of an additional $500 each month.
Over ten years she puts aside $60,000 ($500 times 120 months) plus the initial $10,000 for a total of $70,000. At the end of ten years, she has reduced her home loan balance by $97,912. In effect, she has earned the mortgage rate (5.71%, allowing for compounding) after tax to make a total return of $27,912.
The result would be the same whether she made additional repayments or deposited the money in her offset account.
This strategy delivers a risk-free return, is simple to set up, can be stopped at any time and you can usually access your savings by redrawing the funds or refinancing your home loan.
However, in a low-interest-rate environment, the return is correspondingly low.
Invest the money
Scenario #2 involves Chris taking his savings and investing in an investment portfolio. In this case, I have used the Vanguard High Growth Index Fund, not because I particularly recommend it, but because it invests in a broad range of assets and I have 20 years of historical data to look back on. This period includes both the GFC (2008) and the COVID-19 period, and so spans a good mixture of the good and the bad.
Over the 20 years since inception, this fund has delivered an average annual return (after fees, before taxes) of 8.11% (before tax, after fees), made up of 5.51% income distributed each year and 2.6% capital growth.
The split matters because the annual income return is taxed when received at Chris’s marginal tax rate of 34.5% including Medicare. In contrast, he only pays tax on the capital return when he actually sells and will benefit from the capital gains tax discount, meaning he only pays tax on half the gain.
In this example, I have assumed that Chris pays the tax on the distribution each year and reinvests the after-tax amount.
After ten years, Chris sells the whole investment, pays tax on the gain and nets $100,367, for a return of $30,367 on his $70,000 investment.
This gives Chris an effective rate of return after tax of 6.12% or 0.41% annually more than Kate earned.
Scenario #2b involves Chris taking his savings and repaying part of his home loan before redrawing the same sum and investing it in an investment portfolio. This is a process known as "Debt Recycling" for obvious reasons. Debt recycling is the process of turning non-deductible debt into deductible debt.
There is no change to how much Chris owes in total, no change to the asets he owns and no change to the total interest bill. But now a portion of the interest is tax deductible.
As a result, Chris's return goes up by $8,527 or 1.36% per annum to a toal of $38,894 or 7.48% per annum.
Of course, past performance is no guarantee of future performance, so there is some degree of uncertainty about the return which may turn out to be higher or lower in practice.
Importantly, as markets fluctuate, you may not be able to realise the amount you expect if you need the money in a hurry before the end of the ten years.
The higher return comes at the expense of less certainty and some flexibility. It also takes a little more work to set it up in the first place. Take professional advice before embarking on this strategy. Google is no substitute for quality advice when choosing an investment vehicle to implement this strategy.
Make additional Super Contributions
Scenario #3 involves using your savings to make tax-deductible super contributions with both the initial $10,000 and the ongoing $500 monthly savings.
For simplicity and comparison, I have assumed that Sarah invests in the same assets as Chris did in scenario#2, but in a super fund instead.
This works because you get a tax deduction for contributing and your super fund pays just 15% tax on the money it receives. Moreover, any your super fund pays tax at 15% on income and an effective 10% on capital gains (15% on two-thirds of the growth).
As a result, the initial $10,000 savings will result in a net investment of $11,433 ($10,000 plus the tax deduction of $3,450 less contributions tax of $2,017) which gives compound interest a larger base to start working.
Similarly, to take home $500, you need to earn $763, so by salary sacrificing $763 each month, you reduce your take-home pay by $500 (the amount Sarah is happy to save), but $649 ends up in her super fund.
After ten years, Sarah’s $70,000 in savings has turned into $137,293. The good news is that when she turns 60, she could receive this money tax-free. The bad news is she can’t access it until she turns 60.
Conclusion
| Scenario | Ending Profit | Return | Flexibility | Certainty | Ease of Setup |
| #1 Pay down mortgage | $27,912 | 3 | 1 | 1 | 1 |
| #2 Invest outside super | $30,367 | 2+ | 2 | 2 | 2 |
| #2b Invest outside super with debt recycling | $38,894 | 2 | 2 | 2 | 2+ |
| #3 Make additional Super contributions | $67,293 | 1 | 3 | 3 | 3 |
Scenario #3 (invest in super) will deliver the highest lifetime return based on the tax advantages. However, these advantages come with restrictions on access. For many younger people, this lack of flexibility is a deal-breaker. If you think you might need the money before you turn 60 (for example if you are planning early retirement or are setting aside money to pay for your kid’s school fees or start a business), this strategy will be unsuitable.
I would usually only recommend this approach if you have already built up a pool of investments outside super and have your home loan at a manageable level or are close to age 60.
Scenario #2 (invest outside super), delivers a higher return than paying off your home loan without giving up access to the money. Based on the average reutn and interest rates over the past 20 years the difference may not justify the risk for everyone.
But adopting a Debt Recycling Strategy can add to this return without adding to the risk. I would recommend this as the preferred strategy for people who might need the money before age 60 but are looking at a medium to long time frame (5+ years), have their home loan at a manageable level, and are seeking to diversify.
Scenario #1, delivers the lowest return but with great certainty and is the preferred option if you need access to the money in the short term or you have a relatively high home loan.
So how do you decide when your home loan is manageable and time to move on to strategy #2?
It all depends on your circumstances and attitude to risk. I suggest you use two measures when assessing this.
Your loan relative to the value of your home (the loan to value ratio, LVR).
Is your LVR more than 80%, if so focus on paying down your home loan. An LVR below 80% will allow you to avoid Lender's mortgage insurance if you want to refinance and will enable you to take advantage of getting a lower interest rate. How much less than 80%? It depends on your attitude to risk and what might happen to your income in future. For example, are you planning to have a family and might drop to one salary? For many, 70% is a suitable threshold to consider.
Your payments relative to your income
If your mandatory monthly home loan payment is less than 20% of your take-home income, it's probably time to start diverting savings somewhere else. So if you make $70,000 a year, your monthly take-home pay (assuming no HECS) will be $4,615, so if your loan repayments are less than $923, its time to think about an alternative strategy.
Vince Scully
Founder and Chief Sherpa
With over 25 years in Financial Services from consulting to management, Vince Scully is the go-to guy for wealth management and financial advice. Vince founded the Calliva Group; a fund manager, product issuer, advisor and lender to Government and private clients. Vince is an advisor to the Wealth Management Industry, and prior to his role as CEO at Calliva, a senior member of Macquarie bank’s infrastructure team.
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