A shout out here to Christine Calnan who emailed me about this dilemma – whether it is best to put your savings towards extra mortgage repayments, or should you instead be investing?
This is one that does come up a lot when I’m working with clients, and it’s certainly not a question with a simple one size fits all answer. So let’s take a look at the factors you should consider to find the answer that’s right for you.
Christine observed that whilst the question of whether savings should be put to extra mortgage repayments or investment is something faced by plenty of people, there’s not a lot written about it when you do a bit of Googling. And there’s a good reason for that – the real answer is “it depends”, and no one likes to give, or receive that answer.
Arriving at the answer that’s right for you is very dependent on 2 key assumptions – what will future home loan interest rates be, and what will the return be on your investment.
Boil it down and the question is really, “will I earn more on an investment than I’ll pay on the mortgage?”
Mortgage rates are at historical lows at the moment, typically around 4.5%.
Both the US and Australian share markets have averaged returns of a little under 10% over the long term.
Now there is tax to pay on your share investment, and this is one key reason why there is no one size fits all answer – we live in a marginal tax world where different people pay different rates of tax.
To further complicate matters, Australian shares throw off franking credits, which offset some and potentially all of your tax liability on these holdings.
To lean on the conservative side, let’s assume that a third of your investment return goes to the tax man. Your 10% total return becomes 6.6%, still comfortably ahead of the mortgage rate.
So on this simple analysis, the preferred strategy would seem to be to priorities investment in shares over additional mortgage repayments.
The tricky bit though is considering whether current mortgage interest rates will continue into the future. If you send your savings to an investment, what happens if in 5 years’ time mortgage rates rise to 8%? At this sort of level it would be very tough for an investment to provide an after tax return that would exceed this.
Then there’s the question of share market returns and a topic I’ve raised before – sequencing risk.
It’s all very well to say the average share market return is 9 point something percent, but it varies a lot year to year. Will you actually experience the average return? So with the investment option, you have uncertainty as to the result you will get, whereas under the extra mortgage repayments scenario, you have certainty, you have definitely saved the home loan interest rate. The value of that certainty should not be under estimated. Paying off your home loan is effectively a guaranteed outcome.
To help address the uncertainty of your investment return, you should ensure that when planning your strategy, you’re thinking of a minimum time frame of 5 years, and ideally 10 years plus. The longer you invest for, the more likely it is that your outcome will come in at around the long term average
Perhaps it’s worth considering whether this mortgage vs invest question need be so binary. Could you do both?
At its simplest, if you can save $400 per month you could quite easily put half off that to your mortgage and invest the other half. Hedge your bets.
You could spice things up though. Maybe you direct your savings to investments, but then have all the income those investments produce paid off your home loan. Or maybe you even use some equity in your home to buy investments, potentially creating a negative gearing scenario. You’re savings go towards servicing this new investment loan, and once again the investment income is used to make extra mortgage repayments. Because you’ve borrowed to kick things off, your investment portfolio will be bigger, meaning your investment income will be larger, which means more money to pay off your home loan.
Another way you could go is to focus initially on paying down the home loan with all of your savings, and then once this is done, using the equity in your home to borrow and buy an investment portfolio. So a sequential, rather than parallel approach. The attraction of this is that you’ve achieved the certain saving of having paid off your mortgage, and then once you re-borrow to invest, the interest expense will be tax deductable given the investments will produce taxable income. And because you’re borrowing against your home, the interest rate will be low compared to the alternatives, which will help make the strategy profitable.
The only downside with this approach is the opportunity cost of having no market exposure during the loan repayment phase.
It’s worth addressing the fact that I’ve talked here about share market investments and not property investments. There’s a couple of reasons for this, but it mainly boils down to risk. A well-diversified portfolio of Australian and International shares is far less risky than a single residential investment property, relying on one tenant to pay on time and look after the place. There are also a lot more transaction costs associated with property – stamp duty, agent’s fees, maintenance costs, council rates, and on it goes. Plus, an investment property is a big chunky investment. You can’t do it for $200 a month, and you can’t quickly liquidate it if your circumstances change.
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To answer Christine’s question, on balance, whilst interest rates remain at historic lows, it is likely that investment is a better option than additional mortgage repayments. But you would want a well diversified investment portfolio of 100% growth assets, and keep a close eye on the interest rate on your home loan. If it started to creep up, the answer might flip, at which point you could sell your shares and pay the proceeds off your mortgage in one lump sum. It’s also essential that you appreciate that there is some risk and a positive outcome cannot be guaranteed.
This is very general advice, and I’d strongly urge you to sit down with someone and run the numbers that are specific to you. Your tax circumstances, time frame, job security, and broader financial position are all relevant factors in determining what is right for you.
A reminder that there’s a free toolkit for you to download that provides a simple checklist of the things you should consider when evaluating whether you should be focused on paying down the mortgage or investing. So visit the financialautonomy.com.au web site to grab your copy.
I hope you’ve found today’s post interesting. If you’ve got a question that you think others in the Financial Autonomy community might also face, drop me an email, I’d love to hear from you.
Interested in achieving Financial Independence? Our Invest in Shares with Confidence online course could provide the tools and framework to enable you to succeed. Learn more here.
Resources & Links
- Podcast Version
- Will my Money Run Out?
- Cash Flow Mastery – Online Course
- Invest in Shares with Confidence – Online Course