It is a common dilemma for Australians all over the country. Do you use spare money to pay off your mortgage and reduce debt? Or do you invest it somewhere else in the hope of boosting returns and improving your overall net worth?
Making a decision based on numbers alone is relatively straightforward (I’ll show you this soon). However, it is not that simple. For all of us, there are other considerations that come into play, including our emotional response to money and security. Let’s take a look.
If there were a simple answer, it would be this.
It may be worth investing if the ‘after-tax return’ you get on your investment is greater than the interest rate on your mortgage.
Let’s say, for example, that the interest rate on your mortgage is 5 per cent, with your investment returns 7 per cent at after tax and other costs. Financially, you are 2 per cent ahead. You could reinvest this money or even use it to pay down your mortgage – helping you achieve both goals.
Of course, this approach depends on your personal income and the marginal tax rate you pay. In the table below, you can see how much investment return you need for this strategy to make sense. If, for example, you earn the average Australian full-time income of $81,530 (with a marginal tax rate of 32.5 per cent), you need 7.4 per cent pre-tax from investment to achieve an after-tax return of 5 per cent.
Can you see what this table shows us? The higher your income, the more you need to make on your investments in order for this strategy to work.
There are other things you need to consider such as the impact of variable interest rates and the actual return of the investment. But it does give you a general idea of where your money might be better off.
Some other reasons people choose to invest their money instead of paying off their mortgage include diversification and accessibility.
Some people worry about having all their money tied up in their home. What happens if prices fall dramatically? We can’t predict the property market but diversifying investments can offer some protection.
Another consideration is accessibility. You need a lot of money to buy a property. Investing in shares or managed funds, on the other hand, requires much smaller amounts. It’s also generally easier to get your money out when you need it.
Reasons you might pay off your mortgage instead of investing
· Peace of mind: The emotional aspect of investing is just as important as the numbers. If your number one goal is the security that comes from owning the roof over your head, then that’s what you should do.
· Pay less interest while getting a guaranteed return: Additional money you pay into your mortgage reduces the interest you’ll need to pay and the duration of the loan. Plus, it acts as a guaranteed return. If the interest rate is 5 per cent, you’re effectively getting a guaranteed 5 per cent return on any extra money you add to your mortgage.
· Build equity: The more you pay off your loan, the more equity you have in your home. Coupled with capital growth over the long term, you can borrow against this equity in your home to build a larger property portfolio.
At the end of the day, we all want to sleep easy at night. For some of us that means feeling comfortable with our financial decisions. If your focus is debt reduction, then go with paying down your mortgage. On the other hand, if your goal is long-term wealth creation and the numbers stack up, then look to invest your money at an appropriate level of risk.