Should I invest or pay off my home loan?


Jason Prowd  |  31st August 2018  |  5 min read

Key points:
  • Get ahead financially by using your extra money to pay off your mortgage or invest in shares.
  • Looking at the numbers can help you decide if you can get better returns by investing.
  • Ultimately, the decision depends on your goals and needs.

It’s a common dilemma for Australians all over the country. Do you use your spare money to pay off your mortgage and reduce your debt? Or do you invest it somewhere else in the hope of boosting your returns and improving your overall net worth?

Making a decision based on numbers alone is relatively straightforward. You run the data and see what leaves you better off (I’ll show you this in a minute). But, of course, it’s not that simple. For all of us, there other considerations that come into play, including our emotional response to money and security. Let’s take a look.

 

If there was 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. Meanwhile, your investment returns 7 per cent 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 your investment to achieve an after-tax return of 5 per cent.

 

Table 1: Investment returns required by Income bracket

Your Personal Income Bracket $18,201 – $37,000 $37,001 – $87,000 $87,001 – $180,000 $180,001 and above
Your Marginal Tax Rate 19% 32.5% 37% 45%
The pre-tax investment return required to return 5% after tax 6.2% 7.4% 7.9% 9.1%

See what else this table shows us? The higher your income, the more you need to make on your investments in order for this strategy to work (thanks to your higher tax rate).

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.

Diversification is all about spreading your money around in order to reduce your risk to any one investment. 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 your 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.

 

Three reasons you might pay off your mortgage instead of investing

But of course, the decision is not always a straight-up financial one. There are other factors to consider when deciding whether to pay off your home before investing elsewhere.

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 put onto your mortgage reduces the interest you’ll need to pay and the duration of your loan. Plus, it acts as a guaranteed return. If your 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 it. 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 need to sleep easy at night. And that means feeling comfortable with your financial decisions. If your focus is debt reduction, then go with your mortgage. On the other hand, if your goal is long-term wealth creation and the numbers add up, then look to invest your money at an appropriate level of risk. The answer is up to you.

— Jason Prowd leads Morningstar Next: ready-made investment portfolios. Discover more here

 

© Morningstar Investment Management Australian Limited (‘Morningstar’) and any related bodies corporate that are involved in the document’s creation. Whilst all reasonable care has been taken to ensure the accuracy of information provided, neither Morningstar nor its third-party providers accept responsibility for any inaccuracy or for investment decisions by any person on the basis of the information included. Past performance is not a reliable indicator of future performance. Morningstar does not guarantee the performance of any investment.  Any general advice has been prepared without reference to your investment objectives, financial situation or needs. You should consider the advice in light of these matters and if applicable, the relevant disclosure document before making any decision to invest. Refer to our Financial Services Guide for more information.

 


Source: Australian Bureau of Statistics 6416.0 – Residential Property Price Indexes: Eight Capital Cities, Dec 2017

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