The idea of being mortgage free is very appealing and often a key financial goal for our clients. Paying off your home loan as quickly as possible to avoid paying excess interest has many benefits but many of our clients focused on accumulating wealth are also wondering whether this should be their sole focus. The question is, are there other ways to optimise any spare dollars?
There are some reasonably complex variables to think through which is why there is considerable value in seeking professional financial planning and investment advice.
Which goal is most important?
Deciding whether to pay off your mortgage or invest really comes down to your priorities and your tolerance for risk.
Many people just want peace of mind and there’s no doubt that being mortgage free is a great way to achieve that. Paying down your home loan quickly will minimise the spend on interest for sure, but it is not always a bad strategy to run the full term of your mortgage, provided you put those additional funds to good use.
If your goal is more focused on wealth accumulation it may be prudent to do some number crunching as there may be other ways to invest the money you would have used on extra payments. Provided you invest wisely this could make a significant difference to your long-term financial security.
Do your sums
With interest rates at an all-time low in Australia, it may be worth doing some calculations to help you make your decision.
As a case study, let’s consider you have a 30 year, $500,000 mortgage with an interest rate of 3.5%. Current interest rates are lower than this, but this is just a way to demonstrate, and figures would change as interest rates fluctuate over a 30-year period. Based on these figures the Government’s Moneysmart mortgage calculator indicates that the monthly repayments would be $2,245.
For simplicity we have also excluded the banking fees as they are always variable depending on the lender. At the end of the 30-year term of your home loan you would have paid $308,280 in interest.
If you paid an additional $500 each month, you would pay the mortgage off in 21 years and 9 months and only pay $214,168 total interest – more than eight years sooner which is $94,112 less interest.
If instead you invested the $500 each month, and the average return on the investment was 7.5%, compounding interest could dramatically increase the results over the 30-year period.
The Government’s Moneysmart compound interest calculator indicates that your investment would be worth $678,433 at the time your mortgage is finalised.
In this example there is a staggering $584,321 difference between the amount of interest you saved on your mortgage and the investment you have grown.
Even if the interest rates increase during the life of your mortgage, the return on your investments could still be the greater amount.
Consider your unique circumstances
On face value the example we have provided makes it look as though diversifying your investments is the way to go but there are almost always more complex personal considerations at play.
First and foremost, it comes down to your appetite for risk and what you feel most comfortable with. Both strategies can help you increase your assets. It depends how aggressive you want to be and whether your goal is to reduce debt or diversify your wealth.
Your choices may also be impacted by your lifestyle and stage of life. If you are closer to retirement you will most likely make different decisions to someone in their early thirties.
Be sure to consider the tax implications of the investment, especially if you are earning an income from it. Certain investments will be eligible for tax deductions and higher income earners may also find that the higher tax rate makes it more appropriate to pay down their mortgage.
It comes down to the rate of return
This record low interest rate environment provides opportunities to build wealth outside of the mortgage, using these funds in the future to pay down the loan faster or continue growing the investment for the longer term while the mortgage looks after itself (if cashflow permits). The investment may be in shares, managed funds or property but the key is to ensure the expected rate of return exceeds that of the mortgage and allows for a margin of safety.
Get advice
The decision as to whether you should pay off your mortgage first or diversify your investments is not cut and dried. It is important to do the due diligence. This is where seeking professional advice is truly worthwhile. We can look at your unique circumstances including your appetite for risk, the tax implications, your time horizon, and your liquidity requirements – and we can do the sums to inform your decision and give you peace of mind. Get in touch.
We have an experienced team of financial planners on the Sunshine Coast, Gympie, Brisbane and Ipswich.
