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 2.5%, has $10,000 saved and can commit to saving $500 a month and compare the outcome for three scenarios over ten 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 $51,000 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 $80,293. In effect, she has earned the mortgage rate (2.5%) after tax to make a total return of $10,293.

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 taking your 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 18 years of historical data to look back on. This period includes both the GFC (2008) and the COVID-19 period (2020 in case you’ve been living under a rock), and so spans a good mixture of the good and the bad.

The underlying assets in which this fund invests is the same as the ETF VDHG. I chose the managed fund version because you don’t pay brokerage on each monthly investment.

Over the 18 years since inception, this fund has delivered an average annual return (after fees, before taxes) of 8.42% comprised of 5.3% income distributed each year and 3.11% capital growth.

The split matters because the annual income return is taxed at your ordinary tax rate when received. In contrast, you only pay tax on the capital return when you sell and will usually attract the capital gains tax discount, meaning you only pay 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.

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 in scenario#2, but in a super fund.

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’s access it until she turns 60.

Conclusion

Rank Order
ScenarioEnding profitReturnFlexibiltyCertaintyEase of set up
#1 Pay down home loan$10,9233111
#2 Invest outside Super$30,3672222
#3 Make additional super contributions$67,2931333

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.

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), and who have their home loan at a manageable level.

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.

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