Whether to pay off the mortgage faster or invest is one of the most common questions that gets asked.

Paying down your mortgage (or using an offset or redraw) earns you a return equivalent to your mortgage interest rate, and there is no risk of capital loss (provided it is with an ADI and under the $250,000 government guarantee).

The alternative – investing in shares – has a higher expected return than the mortgage rate. Historically stocks have returned around 10%¹. But this higher expected return is not guaranteed. The higher expected return comes with higher risk, and that higher risk means a wider range of potential outcomes, so your actual return may differ from the expected return.

Some will point out that since the return from paying down the mortgage (or using an offset or redraw) is tax-free due to the return coming from reduced expenses rather than receiving cash, it should be grossed up² before comparing, but with debt recycling (discussed below), investing has the same advantage (and several others³).

The decision to pay off the mortgage faster vs investing is similar to whether to borrow to invest.
Borrowing to invest is suitable where you have:

Equity to borrow against
A high marginal tax rate
Additional cash flow (or cash buffer, or both) to service the interest payments
A long time horizon
A high risk tolerance

With regards to paying down excess funds into your mortgage vs investing:

Having Equity is not an issue.
Having a higher marginal tax rate is less of an issue (but still relevant) at mortgage interest rates.
Having additional cash flow is less of an issue since the question is about additional payments on top of your regular mortgage payments. If you can afford your current repayments, this probably isn’t a significant issue.

The last two items are what needs focusing on – a long time horizon and a high risk tolerance. Both of these relate to the fact that investing to achieve a higher return than the interest cost means investing in growth assets. Since growth assets are volatile by nature, you need a long enough time horizon and a high enough tolerance to see your investment’s value fall significantly in the short and medium-term without selling.

The crux of the decision to pay off the mortgage faster vs investing depends on your risk tolerance.

You have a higher risk tolerance when you:

Have no short term needs for your capital, have an emergency fund, secure income, life insurance
Are younger and further from retirement or financial independence
Are comfortable with debt

A higher risk tolerance allows you to invest more which provides a higher expected return. The expected part is more likely to eventuate the longer you can leave it invested.

If you don’t like debt (many don’t) and fear getting retrenched, especially if you have dependants to look after or worry about being handcuffed to your job to pay down your debt, it’s perfectly reasonable to pay the extra down on your mortgage, even if the long term expected return is a little lower, especially when the operative word is expected return compared to the actual return of paying down the loan.

In summary, your risk tolerance will dictate whether to allocate your additional capital towards safe invetments (the mortgage) or risky investments (investing).

Safe investments are for where you have:

short term needs for your money
a lower appetite for risk (including debt)
little or no need to generate higher returns (nearing retirement or financial independence)

Risky investments are for where you have:

no need access to the capital for a long time (typically 10+ years)
an appetite for higher risk
a need for a higher return

Whatever you decide, don’t switch back and forth based on the interest rate you get on your home loan. Rotating back and forth is the best way to decimate your returns. Pick a strategy and stick to your plan.

And don’t forget – you have the option of doing both. You could put half into shares and the rest into an offset to pay down the mortgage. Don’t feel like it has to be an either/or situation – you may decide to hedge your bets.

If you do decide to invest

Keep a solid cash buffer in an offset as your emergency fund.
Debt-recycle the amount you plan to use for investing (see debt recycling below).

Tax considerations

Super

Superannuation was designed specifically for retirement savings.

Superannuation is not an investment, but rather an investment vehicle/legal structure that holds investments such as stocks, bonds, property, and cash, just like outside super. The difference is that super offers massive tax concessions to boost your retirement savings but is inaccessible until you meet a condition of release (generally, retirement age).

There is an argument for paying into super to invest over paying down your home loan. There’s a strong case to use up your $27.5k threshold each and every year if you’re on a high marginal tax rate (MTR). At 47% MTR, you get an instant once-off 60% return on every dollar you contribute concessionally, which is hard to ignore, even if it means locking it up for 30 years. Even on a 32% MTR, you get an instant one-off 25% return. On top of this, there are ongoing tax savings on dividends and a compounding effect on all this additional money.

For an early retiree, you have to weigh up the lack of access to these funds and the potential changing laws around when you may be able to access them.

This list of articles on superannuation has a lot more information, including:

What is superannuation?
When can you access super?
Superannuation contribution types
Superannuation account types
How to invest your super
And much more.

Debt Recycling

While savings used to pay down your home loan are tax-free, and earnings on investments are taxed, you can reduce the tax on your investment earnings via debt recycling, effectively nullifying this specific point as an advantage of paying down the mortgage over investing.

Debt recycling is a strategy to convert (recycle) your non-deductible debt into tax-deductible debt.

Let’s say you had a $100,000 loan on your home with an interest rate of 4%. That means you are paying $4,000 each year in interest. If you were able to convert that to a tax-deductible loan, you would be able to take that $4,000 off your taxable income and if your marginal tax rate was 30%, you would pay 30% x $4,000 = $1,200 less tax each year. The result is that the government effectively pays for 1.2% of that 4% interest, and you are only paying 2.8% interest.

Whether interest is tax-deductible does not depend on what you borrow from. It depends on what the borrowed money is used for.

A PPOR (principal place of residence – the house you live in) is not an investment, so the interest on a loan used for your PPOR is not tax-deductible.

However, if you have money to invest, you can pay down your PPOR loan for that amount (thereby reducing non-deductible debt) and reborrow it out. When you use that borrowed money for purchasing income-producing assets, you have recycled your non-deductible debt into deductible debt, and the interest on that portion of your loan is tax-deductible for the life of the loan while it is invested in income-producing assets. For those with a home loan, debt recycling is one of the best tax-minimisation strategies outside of super.

In addition to the benefit of reducing tax, debt recycling also helps you build an investment portfolio outside of super that can continue to provide passive income once your home is paid off, and which can supplement your superannuation while also being accessible before you can access super.

This article on debt recycling goes into a lot more depth, and includes:

What is debt recycling?
What are the tax implications of debt recycling?
Debt recycling vs borrowing to invest
What can you debt recycle?
What to watch out for
Debt recycling steps
Interest only or Principal & Interest loan
High-yield or low-yield investments for debt recycling
When should you not debt recycle
Is debt recycling legal?
Debt recycling vs concessional contributions to super

¹ The Australian Equity Market over the Past Century | RBA. Table 1 shows returns of 10.2%.

² Grossing up

As the return from paying down your main residence loan (or offset/redraw) is tax-free, ‘gross up’ the rate to get a pre-tax return equivalent.
Using 4% interest rate and 32% marginal tax rate (including the 2% Medicare levy):
4% x 1/(1 – 32%) = 5.9%
However, as noted, debt recycling has the same advantage.

³ Investing has the following benefits to produce a higher return than cash:

the risk premium of stocks – typically about 5-6% over the central banks official cash rate, or 3-4% over mortgage rates
returns on delayed taxes on capital gains (and the long term compounding of these returns)
the ability to sell down investments in retirement on a low or zero tax rate
the 50% CGT discount
franking credits