Back in the days of “normal” interest rates the simple answer to the question “what do I do with any surplus savings?” was “pay off debt”. That’s still a sound strategy for anyone paying high rates of interest on credit cards or personal loans.
Although, if your only debt is your mortgage, and if mortgage interest rates are at the lowest they’ve ever been, does paying it off more quickly provide a good bang for your buck? If not, what are the alternatives?
Taking Down The Mortgage
Take this as an example – you are a 55-year-old senior manager and following a pay rise you estimate that you will be able to commit $1,000 per month of your pre-tax income to building your wealth. The mortgage on your home still has 15 years to run. With an outstanding balance of $220,000, an interest rate of 2.25% p.a. and monthly payments of $1,441, you examine the outcome of following the traditional advice of adding your new savings capacity to your monthly home loan repayments.
But how much can you really save? The marginal tax rate is 39%, including Medicare levy, so after the tax office takes its bit, you are left with just $610 per month to add to your current mortgage repayments. Even so that’s enough to see your home loan paid off in 10 years, allowing a debt-free retirement at the preferred retirement age of 65. Knocking five years off the loan will save you a lot of interest, but is there a better alternative?
A Super Idea
So, now it’s time to examine the option of letting the home loan take care of itself for a while and to exploit some of the wealth creation opportunities offered by superannuation.
Under a salary sacrifice arrangement you could contribute $1,000 of your pre-tax income to your desired super fund. The tax office will still take its cut, but at just 15% you will be left with $850 per month to actually invest. That’s a handy boost right there.
Then there’s the investment return. Paying down your mortgage provides you with an effective investment return on your after-tax savings of 2.25% p.a. With ten years to go until your preferred retirement date it’s appropriate for you to invest your super in a balanced or balanced-growth portfolio with good expectations of significantly higher returns. So, let’s see how things turn out if your super fund achieves a net return of 6% p.a. after fees and tax.
First, the mortgage: after ticking along with minimum payments of principal and interest for ten years it still has an outstanding balance of $81,712 – hardly the debt-free status that you were aiming for. But what about the super savings strategy? Due to the combination of tax advantages, higher returns and the power of compounding interest, your super fund is worth $139,297 more than it would have been if you had opted for the pay down debt strategy. After withdrawing $81,712 tax free from the fund and paying out her mortgage, you’re $57,585 better off under the super strategy.
While delivering lower returns during times of low interest rates, paying down debt does provide an effectively risk-free return equivalent to the interest rate. Your super strategy comes with a higher level of pure investment risk, and it is important that you are comfortable with the ups and downs that balanced, and growth funds are likely to experience.
It’s also important to recognise that our situations are all unique. The same strategy won’t suit everyone, so talk to your financial planner at Tanti Financial Services about designing a savings strategy that’s right for you. To book in your consultation, contact us via our online form or phone (02) 4735 6644.