Updated Feb, 2020

Pay off the mortgage faster or invest?

pay off the mortgage faster or invest

Paying down your mortgage (or using an offset or redraw) earns you a return equivalent to your mortgage interest rate, and this is a guaranteed return.

The alternative, investing in shares, has a higher expected return than the mortgage rate. Historically stocks have returned around 10%. 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 paying down the mortgage is tax-free, it should be “grossed up” before comparing, but with debt recycling (discussed below), investing has the same advantage.

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

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

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

Tax considerations

Super

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 $25k 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 non-concessional dollar, which is hard to ignore, even if it means locking it up for 30 years. 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.

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 refers to converting (recycling) 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’re paying $4,000 each year in interest. If you were able to convert that to a tax-deductible loan, then if your marginal tax rate is 32.5%, you will be able to take that $4,000 off your taxable income and therefore pay 32.5% x $4,000 = $1,300 less tax each year. The result is that the government is effectively paying for 1.3% of that 4% interest, and you are only paying 2.7% 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) 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.

One more thing — if you do debt recycle, make sure dividend auto reinvestment is not enabled and instead redirect dividends back into the mortgage to reduce your non-deductible debt further.

Difference between an offset and a redraw facility

An offset account is legally a savings account. Any money in there is still your money, and you can take it out whenever you like without restriction.

Paying money into a redraw facility is legally considered paying down the loan. There are two consequences to this.

  1. The bank can decide not to allow you to redraw it out (yes, this happens, particularly if they see a change in your spending patterns on a credit card from that bank indicating you may have lost your job, which incidentally is the time you desperately need the money); and
  2. When you take money out, it is considered a new loan for tax purposes. If this newly borrowed money is used to purchase income-producing assets, the interest is tax-deductible, otherwise it is not.

Note that some smaller banks offer a product that they call an offset but is actually a redraw. You could be locking up a considerable amount of money without realising until it is too late. Always check the fine print.

Consequently

  1. If you decide to pay down the mortgage and if you want to ensure that you still have access to it later in case you need it, instead of paying down the loan directly, put it in an offset (not a redraw).
  2. If you decide to invest in shares (outside of super), keep it in an offset until you’re ready to invest it. Once you’re ready to invest it, pay down your PPOR loan and reborrow it and use that for investing. Using this money to buy income-producing assets makes the interest tax deductible which would not be the case if you purchased the shares directly without paying down your PPOR loan first and then redrawing it out to invest.

Don’t use a redraw for investing — get a separate loan split instead

While technically you can use a redraw to pay it down and borrow it out, you should instead contact your bank and pull your money out into a new separate loan split so that the money you pay off and then pull out for investing is not mixed with funds that you draw out for personal use.

Mixing is where you use some of your funds for investing and some for personal use.

Mixing is not only going to be a nightmare for your accountant trying to apportion it to figure out how much you can claim, but if it cannot be clearly apportioned, you may lose the tax destructibility entirely. If you find this out in an audit in 10 years, that’s likely in the tens of thousands of dollars you would have to pay back.

The next issue of mixing is that when you pay back some of it into the redraw, it may be considered to be paid back in proportional parts. So if you used 20% for personal use, 40% for an investment property deposit, and 40% for shares, and if you paid back 20% thinking it was for the personal use and that you can now claim 100% interest from then on, if you get audited you may get a rude shock to find out that 20% of the remaining loan continued to be considered for personal use.

For the majority of people, redraws are misunderstood and are very costly mistakes waiting to happen.

To avoid mixing, get a separate new loan split for each new purpose so that they’re clearly segregated.

With some banks, you can split your loan over the phone, whereas others will require paperwork. Take a look at terryw’s tax tips for more information.

If you plan to go down the route of debt recycling, speak to an accountant who has done this before to make sure it is done right – this is not worth making a mistake on to save on the cost of getting professional advice.