December 3, 2023
One of the biggest debates in personal finance is whether to pay off your mortgage or invest.
Both camps put forth well reasoned arguments on the benefits and drawbacks of both options.
But when interest rates shoot up, as they have recently, it prompts many people to ask questions:
“Is it still better to invest when rates are this high?”
“Maybe I should pay down my mortgage since the savings are better now”
“Does debt recycling still make sense?
While these are all good choices, surely there has to be a right move on the chess board?
Let’s flesh out the options and consider what’s changed now that we have higher interest rates. I’ll also share what I’m doing and why, and how I’d approach it differently depending on my situation.
The benefits of focusing on paying off your mortgage when interest rates have risen is pretty obvious.
Essentially, you now earn a higher return on your money for paying down debt. Saving yourself 6% interest is a hell of a lot better than 2%!
The return is also guaranteed and non-taxable, making it more attractive again. There’s no volatility and uncertainty involved with paying down a mortgage. You put dollars in = balance goes down.
Not to mention, many people naturally find smashing the mortgage more motivating than investing. The higher return now makes that better – like a ‘best of both worlds’ kind of vibe.
You might also point out, “Looking back at history, interest rates aren’t even that high, they could go higher!”
That’s true, they could. And while I don’t have a crystal ball here, I do think it’s unlikely mortgage rates go much higher than they are now.
At the time of writing, economies seem to be slowing as previous rate hikes work their way through the system and affect people’s spending power (the US is a little different as most mortgages are not variable like ours).
By the way, I’m using ‘high’ as a relative term, referring to the recent decade of low interest rates. I’m well aware that interest rates have been much higher in decades past.
So what about investing? The case for investing when interest rates are higher is less obvious.
As rates go up, it makes safe options like cash and bonds more appealing. So it makes people think, “Maybe I’ll just hold off investing for now, since I’m getting such a good rate on my cash.”
This often has a counterbalancing effect of slowing or reducing asset prices, as they become relatively less attractive.
The returns of ‘safe’ assets have increased, but what about the returns on stocks and real estate? We’ll discuss this a bit more soon, but if we take a long term view, the long term expected returns are likely not that much different from normal.
Dividend and rental yields are both a bit higher, and the multi-decade growth outlook is probably about the same. By that I mean, it’s unlikely that interest rates have materially changed future rates of economic growth, profits, and productivity.
On the surface, higher interest rates have not improved the attractiveness of investing anywhere near as much as the appeal of paying down debt.
And yes, inflation plays a part here and eats into our returns, but that’s true of everything, including our spending power and relative wealth.
Let’s pivot now to look at this decision from a different angle.
If you’re on the fence on the whole mortgage vs investing thing right now, here’s what I’d ask:
What was your original choice and why? Was it investing? Or was it paying down debt?
Some would suggest that the return estimates for both are probably similar right now (perhaps 6-8% per annum for investing after tax, and 6% for the mortgage). And while it might sound strange, here’s why I don’t think that’s the right way to think about it…
Your mortgage rate, and the expected return on stocks or other investments, changes over time.
In fact, most discussion I’ve seen ignores this completely. One reason for this could be that people get overly excited about the higher ‘guaranteed’ return of paying down their mortgage. So excited that they forget to consider the bigger picture.
Those extra mortgage repayments save you 6% interest right now. But if rates fall back to 2% again, your lower mortgage balance is no longer saving you as much.
If you had invested and retained a higher mortgage balance, that same debt would now only be costing you 2% interest once again. And by that time, shares will have moved higher.
Notice how share markets have fallen as rates have increased. And what do lower share prices typically mean? Higher future returns. Maybe not immediately, but at some point.
Falling rates tend to boost asset prices (if they weren’t already growing). So with the ‘switching’ approach, you’d likely be reallocating money to investments after prices have risen.
For multiple reasons – practical, numerical and behavioural – I think it’s better to work on the general assumption that investment returns are likely to outpace the average mortgage rate over time.
But, there’s an important caveat to that.
Some people will tell you investing will outperform paying down debt with near-certainty because of the “market efficiency” I just described.
But in reality, it depends entirely on timeframes. In truth, there are many periods where share market returns are poor (even 5-10 years at a time), and paying down the mortgage would outperform.
Back in 2020, I remember seeing people saying not to lock in fixed rates of 2% or less because “variable rates always work out cheaper, it means rates must be going to fall even further!”
The point is, there are exceptions to everything, and general rules of thumb don’t always apply.
Unfortunately, returns aren’t always forecastable in advance based on valuations. You can’t know what people will want to pay for assets in 10-20 years time.
What yield will they demand? What multiple of earnings will be deemed fair? How will the economy be doing? And what will rates be at the time?
Many ‘experts’ called the US market overvalued from the early 2010s. They were hopelessly and spectacularly wrong, missing the longest bull market of all time for US stocks underpinned by a huge run-up in profits and dividends.
Anyway, investments outperforming the average mortgage rate is not a given, so this uncertainty is worth taking into account. Always consider your own psychology when making financial projections, especially around “what if this doesn’t work out like I expect?”
By the way, you can keep tabs on your annual dividend income using the spreadsheet I created. I’ve used it for years as a way to help plan my finances and watch my progress. Get it below.
Just like when rates are lower, deciding whether to use savings to invest or pay down your mortgage is a personal choice.
As always, there are pros and cons on both sides. The right move depends on which benefits you find most appealing.
On one hand, paying down the mortgage is a guaranteed return. On the other hand, investing is likely to offer a higher long term return.
Here’s a few questions to help you think it through:
1- What do you find more exciting or motivating: seeing your mortgage balance go down, or your investment portfolio go up?
2- Which outcome to you want: a debt free home, or a much bigger pile of investments?
3- Do you like the idea of lower expenses, or more income?
4- Are you planning to retire or semi-retire in the next 5-10 years?
Let’s flesh out this last one, it’s important.
You might be better served getting rid of your mortgage repayment if planning on stepping away from the full-time workforce sometime soon.
Reason being, it’ll probably make a bigger difference of your overall cashflow than having more investments.
$400,000 worth of shares may produce $16,000 of investment income. But a $400,000 mortgage will currently cost you a lot more in repayments. Likely closer to $30,000.
The point is, if you’re looking at optimising your cashflow to reduce work, getting rid of a mortgage can be more impactful. Keeping a mortgage at higher interest rates increases how much you need to reach FI, which is pretty damn annoying.
If you’re in this situation, don’t get caught in no-mans land. Paying off half your loan isn’t very helpful, because you still have the same monthly repayments!
Here, you have a few smart choices:
1- Pay off the loan completely.
2- Get the bank to recalculate your repayments to the new minimum.
3- Refinance to a fresh 30 year loan term to minimise the repayments even further.
Failing to do this means you’ve dumped a bunch more money into your loan, yet not improved your cashflow whatsoever.
For those just starting their journey, or with a longer time horizon, it’s likely to be more fruitful focusing on long term investments for reasons described earlier.
If you’ve decided that investing is the more attractive option, but still have a mortgage, you may want to look at debt recycling.
To be clear, this only makes sense if you’re good at managing money and accounts and don’t mind a bit of extra complexity.
Remember, this is not about borrowing more money to invest. It’s about re-routing savings which are destined to be invested through a mortgage first.
If you’re looking at investing anyway, debt recycling is now more attractive than before. Here’s why…
Say you have a $500,000 home loan with a 6% interest rate, and $100,000 cash.
Option A: Investing without debt recycling.
Invest $100,000. Receive $4,000 of income. If tax takes 37%, you’re left with $2,500 income.
Option B: Investing with debt recycling.
Pay down $100,000 of debt (your non-deductible home loan). Redraw $100,000 and invest it. Receive $4,000 of income.
This time you can claim $6,000 of interest as a tax deduction (interest on $100,000). You can now claim an income tax loss of $2,000 on your investment, which results in a tax refund of about $700 refund (at 37% tax rate).
With both options you have $500,000 of debt. You’ve paid $6,000 of interest for the year. You’ve invested $100,000. And you’ve received $4,000 of income.
By debt recycling, the tax position changes from having to pay $1,500 tax, to getting a refund of $700. Overall, that’s an improvement of $2,200.
On the $100,000 investment, that’s a return boost of 2.2% per annum.
Now, I can’t think of many ways to juice your returns without taking more risk, but debt recycling ranks pretty damn high on the ideas list.
You can always get a tax expert to run through the numbers for your particular scenario. And a good mortgage broker can help you set up the loans correctly to make it easier. But I hope this explains the potential benefits (see my full guide for more).
As interest rates have risen, so have the benefits of debt recycling.
In general, a higher interest rate means there are more tax savings to be had. And if your tax rate is higher than what I’ve quoted, it’s more again. So if you were on the fence about debt recycling before, it might be worth a closer look.
It’s certainly one way of dealing with the annoyance of higher mortgage rates!
In short, I’m continuing to make my regular mortgage repayments, on our home and rental properties, and if there’s spare cash available, I’ll invest it.
All our debt is tax deductible, including on our place of residence. I’ve already done debt recycling after using another unusual strategy. I explained all of that in this post.
Given all debt is deductible, paying it down isn’t very attractive to me at the moment. If I was looking to semi-retire or leave work in a few years, then paying down debt would be a lot more appealing.
But in our particular scenario of already being FI, not caring about debt, and earning part-time income, investing is the winner.
That said, if money became tight or we both wanted to go travelling and not do any paid work for the foreseeable future, I’d at least think about getting rid of the mortgage to simplify our cashflow and reduce expenses.
Deciding whether to pay down your mortgage or invest is now a harder decision than before. By the way, if you know someone who’d be interested in this post, please share it with them.
When your home loan only costs you 2%, it’s easy to throw all your money into investments. But with a 6% interest rate, paying down debt becomes a lot more appealing and the winning choice isn’t so clear.
My advice (don’t tell ASIC): choose an option that aligns with your priorities, your personal goals, and your risk tolerance. Maybe it’s destroying the mortgage. Maybe you stay committed to investing. Or maybe you decide it’s a good time to start debt recycling.
Psychological factors aside, it’s best if you can pick a strategy and stick to it. Because as I mentioned, the expected savings and returns for each option changes over time.
Flip flopping from one to the other is probably just going to result in a sub-optimal outcome, with lots of ongoing uncertainty and decision fatigue around if and when you should switch options again.
Let me know what your plans are in the comments below. I’d love to hear about your current strategy in the current interest rate environment. Has it changed at all? If so, how?
Recommendation: If you’d like help with debt recycling, getting a better mortgage rate, or anything else home loan related, I can happily recommend my personal mortgage broker More Than Mortgages.
I’ve used them for 10 years now and they’ve been great. If you haven’t had your home loan reviewed for a while, there’s a good chance you’re getting screwed!
If you happen to get a new loan through More Than Mortgages, this blog may receive a small commission at no cost to you. I only recommend things I use myself and genuinely approve of.