May 4, 2019
“Should I pay off my mortgage or invest? Or should I put money into Super?”
These questions come up all the time for people looking to reach Financial Independence, or simply build a better future for themselves. And it’s a tricky one, because it depends on a lot of things.
Then of course, everyone has their own opinion on what’s the best option. So today, I’ll add my own thoughts to the pile and hopefully get those brain-juices flowing a little! But remember, nothing here should be taken as financial or investment advice – see my full disclaimer here.
Putting money into Super is not generally a strong focus for those looking to retire early. And in my view, that makes sense, given we can’t access the money until we’re 60 or older.
In this case, investing or paying off a mortgage usually fit the person’s goals better. But in some situations, the trade-off is much harder.
It really depends on your age and expected time-frame to retirement. Essentially, at your current savings rate, how long is it going to take you to build enough investments to live on?
Let’s say someone is over 40 now, and they expect to be somewhere close to Financial Independence at 55 or later. In that case, I would personally focus on investing mostly in Super, while building a small portfolio outside Super.
Then in the last few years I’d save a big pile of cash. Between 55 and 60+, I’d live on the investments, pile of cash and possibly do some part-time work to tide me over until I could access Super.
There’s a million possible scenarios – obviously I can’t run through them all! So that’s just one example of how I’d approach a late stage FI journey.
While you can never know the future, there are calculators made for people taking a blended approach to FI (super plus investments). I haven’t used it personally, but Aussie Firebug has one which may help you make some guesstimates.
And the government could change the rules around what age we can access Super in the future. One thing we know for sure is, we can’t rely on things to stay the same!
But if using a blended approach to FI like this, make sure you have a good Super fund. In fact, everyone should do that anyway!
I don’t have a favourite, but I’d choose a fund that offers a high growth (or 100% shares) option at low cost. This is likely to offer highest returns over the very long term.
Some of the better fund providers include Sun Super, First State Super, Hostplus, Australian Super and REST. See Pat the Shuffler’s investigative look at a few funds here.
In general, for people in their 20s and 30s wanting to retire early, Super is a much less attractive option. With a decent savings rate, there’s no reason why you can’t retire in 10-20 years on an investment portfolio built outside Super.
So in that case, I wouldn’t put a single extra dollar into Super.
The biggest catch-cry from the pro-Super crowd is the tax advantages. And there’s no arguing about that. With a tax rate of 15% on contributions and investment earnings, that’s likely to be a much lower tax rate than most readers are on currently.
There are limits of course. But given most readers are probably on a tax rate of at least 32%, that’s a pretty big free kick. However, those of us interested in Financial Independence need a pool of investments outside Super that can pay our bills.
So we need to concentrate our efforts into building those investments to create that freedom faster. Yes I know the tax benefits of Super are very attractive.
But a big investment account you have no access to, isn’t much bloody good if you want to retire early, is it!?
That leaves us with two other long-debated options. Paying off the mortgage vs investing.
Some assumptions in the calculations here. This is your home, not an investment property. And the comparison is against investing in the sharemarket with no leverage. This makes for the cleanest, simplest, and for my readers, probably the most common comparison. Assumes a 4% interest rate and 7% long term return from shares. Also that shares are held long term, not sold at the end of the period. Okay…
It’s often said that a 4% mortgage interest saving is equivalent to a much higher return from shares, since there’s no tax payable. Because a 7% return, that’s taxed at say 50%, leaves only a 3.5% net return. And a 7% return taxed at 35% leaves only 4.5%, which isn’t a huge jump from today’s mortgage rates.
So the answer is, focus on your mortgage first, as there’s no benefit to investing? Hmm. I don’t think that’s quite right for a few reasons.
First, what matters is your after-tax return. Not an ‘equivalent’ or hypothetical return. And in this case, the after-tax return is 4%.
Now to our shares example. What’s often missed is, this 7% return is not entirely taxable. Some is income and some is growth. In Australia, this would be 4% dividend yield and 3% growth. But only the dividend income is taxable. And because of franking credits, the investor gets a tax credit of 30%.
So for an investor on the highest tax rate (47.5%), there is some out of pocket tax to pay. This brings the after-tax yield down to 3%.
Once you add growth back on, the after-tax total return is 6% per annum. This means only 1% of the entire return was lost to tax, for the highest tax-paying investor. For anyone on a lower tax rate than 47.5%, the result is better.
Australian shares are very tax efficient. Even under the worst case scenario, investing still seems to offer stronger returns. And for most people, likely a decent bit higher than current mortgage rates of 4% and below. Let’s look at that now.
Let’s say you have a 30 year mortgage of $400,000. Your interest rate is 4% and your repayments are $1,910 per month. Over the life of the loan, your total repayments would be $687,478. That’s made up of $400,000 in principal and $287,478 of interest.
Now let’s say you also have saved up a lump sum of $50,000 and you can’t decide whether to invest it or pay down your loan. Let’s assume you put that into your mortgage.
Your new total repayments over the life of the loan are $591,712. This means you saved yourself $95,765 in mortgage payments. And your new loan only takes 23 years and 8 months to pay off. Pretty good!
A $50,000 lump sum earning a return of 4% grows to a total figure of approximately $128,000. Invested at an after-tax return of 6% (as above) in shares, your $50,000 would grow to around $190,000 over the same period.
Now let’s say you decided to use your monthly savings to pay off your home loan, rather than invest. We’ll assume you throw an extra $1000 at your mortgage each month.
In this scenario, your $400,000 loan would be paid off in around 15 years. Your total repayments would be $535,924.
Here, you saved yourself over $151,000 in interest costs over the life of the loan. In this scenario, at a 4% return, your total after-tax funds grow to $253,000. Investing this $1,000 per month for 15 years at 6% per annum in shares, you’d end up with a balance of about $301,000.
Both the mortgage and investment figures are before inflation. Think about how the value of debt declines in real terms all by itself. Due to inflation, $400,000 of debt today won’t feel anywhere near as much in 20 years time.
An offset account is a fantastic invention which Aussies are using to their advantage. This way, every dollar of spare cash is then effortlessly reducing the monthly interest bill. But it tends not to be a permanent scenario. Having a mortgage completely offset with your savings, forever, is pretty unlikely!
So the options are usually, invest that money or pay off the loan. Of course, you can do both using debt recycling, but that’s a whole other topic.
Initially, I did this post with some incorrect calculations which made the mortgage option look less attractive. I got this wrong and was admittedly influenced by another article I’d read on this topic. Apologies if this altered anyone’s views unnecessarily.
My view is still that investing is quite often the more attractive option. But I completely understand the certainty that comes with less debt and the guaranteed return of mortgage savings!
There is, however, a danger of focusing on the mortgage first. And that danger is laziness. I’ve heard of more than a few couples being so happy to be mortgage free that they relax their finances a bit, as a reward. But a number of years later, they’re still debt free but they’ve got nothing else to show for it.
This is a great position to be in. But having zero passive income is hardly the reward you want after so many years of saving. Also, you then have all your savings tied up in an illiquid asset. By investing in shares while keeping your mortgage, this gives you diversification.
So I think beginning to invest while still having a mortgage keeps you sharp, and allows you to benefit from higher returning investments and get compounding working harder for you. Later on, you can always cash in chunks of your investments to pay off parts of your mortgage if you really want. Be mindful of tax, obviously, but the option is there.
Some people aim to do both – pay off the house and build investments to live on, with the aim of timing it so they can be mortgage free at the time they reach FI. And honestly, that’s not a bad way of doing it.
If you want the certainty of less debt, I totally get that. It makes your cashflow more predictable, for one. And nobody can deny the psychological and happiness boost from having your own home paid off. A paid off home also gives you lower living expenses, forever. That’s very cool!
Another big win for the mortgage option is the forced saving element. While I’d normally say discipline is better, some people really need this. And this option is effortless too. Simply increase the repayment amount with the bank or setup an auto transfer when your pay goes in.
Having said that, I would still focus more on investing for higher long term returns and a faster road to freedom. But maybe that’s just me!
It’s pretty clear by now I think investing in shares is likely the best place to put long term savings for many people wanting to reach FI. Here’s a couple of reasons why.
Long term returns are very attractive. Global markets have averaged returns of around 5% after inflation since 1900, according to the Credit Suisse Global Investment Returns Yearbook. Australia has been a bit higher at around 6.5%. That tells us nothing of the future of course, other than if we’re lucky, hopefully we can expect that 5% real return to continue.
In modern terms, with inflation of say 2%, that gives us an expected return of 7% per annum. That is lower than history, but inflation is generally lower and more stable these days. And investment fees are now basically zero too. So net returns, after fees and after inflation, are likely to be just as good. For the hassle and effort involved (almost zero), that’s appealing to me!
Your income increases with inflation, or faster. While debt is worth less each year due to inflation, your shares will throw off dividends which grow over time with company profits. And that tends to be with inflation, often more.
Because of this, if you invest in shares, any year you decide to start paying down debt, you’ll have more income to do it with, in real terms. So investing first, gives you more firepower to pay down debt later.
Higher returns vs mortgage. As mentioned earlier, if you’re on a 47% tax rate, you’ll likely still earn a long term return of 6% after-tax in shares. Lower taxpayers will end up with a bit more. So that’s perhaps 2-3% higher than current mortgage interest rates.
Maybe that doesn’t sound like much. But imagine all the cash a good saver would be pouring in over a 10 or 20 year period. That’s a shitload of compounding returns missed out on!
For higher taxpayers, there are also more tax efficient ways to invest in shares, for those interested in LICs.
On my journey to Financial Independence, I focused solely on saving and investing. And starting today, I’d do the same thing (but would invest differently).
If I had a mortgaged house, I’d probably invest the bare minimum every single month. And if possible, I’d refinance every few years to a new 30 year mortgage term, to lower my repayments. This would leave more cash leftover for investing and see the mortgage get even cheaper over time due to inflation.
Of course, there’s no rule that says you can’t do both. But I’m kind of an all-or-nothing guy! If mortgage rates were higher (say 6% or above), then maybe I’d focus on the mortgage.
Here’s a few ideas for the current environment.
Home loans are now available at around 3.5%, it’s less attractive than ever to pay off debt, in my eyes. Not only that, interest rates are expected to fall a bit further from here. So you can take advantage of it by either paying off your home sooner, or using that extra cash for investing.
Aussie shares still look like a good option compared to other markets and asset classes. The dividend yield of the market is about 4.3% (at time of writing). And the long term outlook for Australia’s economy is attractive.
In the short term, as always, I have no idea what the sharemarket will do. But between you and me, nobody else does either! 😉
Another option I find interesting is peer-to-peer lending. I’ve been investing in this space using RateSetter for a few years now. We’re invested mostly in the 5 year market where interest rates are currently over 7% per annum. Here’s a snippet of the main market rates right now (3/5/19)…
Those rates are lower than recent years due to the platform getting more popular – RateSetter just reached $500m in loans. But the yields are still pretty attractive if you’re in a low or no tax environment.
From what I’ve seen, other platforms can’t match what they offer. Open to everyday investors, who can start with $10. And a provision fund in place which has covered all loan defaults since opening in Oz in 2014, and since starting in the UK in 2009.
Many are only open to ‘sophisticated’ investors (big money). And most have no provision fund in place, so while the interest rates look high, the return is less reliable – you have to cop the losses yourself.
With RateSetter, no investor has ever missed a payment of principal or interest. The provision fund is not a guarantee, but it’s been managed very well so far.
You can find out more in this overview of our experience in peer-to-peer lending with RateSetter I wrote a while back.
And remember, Strong Money readers get a $100 bonus when they signup with my link and invest $1000 in the 3 year market (this blog also gets paid for referring you, so if you sign up, thanks!).
As always, where to put your money is a personal choice. So there’s no right answer for everyone, and indeed, a combination of things is what most people go for.
Many times, it’s more about psychology than it is about numbers. So if you’d simply prefer to be debt free, then by all means, pay down that mortgage with no regrets.
But if you’re happy to accept more risk in the short term, for higher returns in the long run, then investing is the way to go. I think building an income stream from investments is the fastest road to Financial Independence.
What’s your view on these different options? And where are you putting your money at the moment? Let me know in the comments.
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