This is a common question we receive from clients and we’re not surprised if you have also been wondering the same thing.
It really comes down to what you are trying to achieve – what your personal goals are. Most clients say they want their home paid off as soon as possible. Why is that? In our experience, we’ve found it’s due to the security that comes from knowing your family will always have a roof over their heads, in good times and in bad. Also, more and more these days it's because of the terrifying possibility that you'll retire with a hefty mortgage - a possibility that is all the more likely if you live in Sydney or Melbourne!
Let's take a look at your options.
As you pay down the principal on your mortgage you are reducing the amount owing and are therefore paying less interest on the loan each year. This gives you a guaranteed saving on your interest bill. A dollar saved is a dollar earned! This is generally a good strategy when interest rates are low because it means you can afford to pay down more of the principal when the interest component of your repayments is less than it would be when rates are higher.
There is another advantage to putting your spare change onto the mortgage rather than saving it up or investing separately (i.e. not in super) and that is because any earnings you make on these outside investments (e.g. savings account, term deposit, listed shares) will be taxable, whereas the extra money put onto the mortgage simply reduces your annual interest bill. If you really did want to invest the extra savings you'd need to be sure that the return on these investments after tax was greater than what you'd save by putting into the mortgage, not always a simple thing to do without risk.
If you want to put extra money into super, then that is something the Government encourages by providing tax breaks for contributions made into superannuation and on the earnings in the super fund. The theory is that the more money invested which can’t be accessed until retirement (and reaching a specific age) means fewer Australians will be reliant on the age pension.
Contributing to super personally may provide you with a tax deduction thereby reducing your tax bill. You will also be investing your retirement savings more tax effectively because your super will only be paying tax of 15% on contributions and earnings. If you are earning more than $250,000 income then the contributions tax goes up to 30%. Compare these rates with whatever you're currently paying personally (anywhere up to 47%).
Now, let's compare
Let’s use the example that you are earning $200,000 p.a. (note that earnings over $180,000 attract a 47% tax rate) and you want to use $5,000 of your gross wage to pay down your mortgage or contribute to super. If you pay down your mortgage you are not reducing your taxable income so you would lose $2,350 of the $5,000 to the tax man (47%) and your mortgage would only be reduced by what's leftover, being $2,650.
On the other hand, if you contribute the $5,000 to super, your superannuation fund (not you) would only pay $750 in tax. That’s a net tax savings of $1,600 and you would have $4,250 after tax being invested in a low tax environment.
If we were to assume a higher than usual interest cost of 4% on your mortgage by paying down your home loan you would only be reducing your annual interest costs by $132.50 after tax.
To take this another step further, if we assume a moderate return of 5.5% p.a. in your super then, the after tax earnings from the $4,250 would be $198.69. This added to your initial tax saving of $1,600 provides a compelling case of super assisting you to build long term wealth.
It is also possible to draw super at retirement to help pay off any non-deductible debt (i.e. your home), so this could also be part of a long term strategy.
What should you do?
So should you pay down your mortgage or contribute to super? That will depend on your situation, goals and needs:
- What is your cash flow position?
- How soon can you access funds in super?
- What’s your current marginal tax rate?
- Do you have an appetite to invest?
- Are you ready to seriously save for your future?
The next step of course is to look at how to actually invest in super. That is another conversation altogether.
If you're thinking about what's best for you and your family when it comes to debt, finances, insurance, superannuation and planning for your future, why not get in touch with the team at Generate Wealth? We'd love to help.