Nadine Higgins is the host of NZME's personal finance podcast The Prosperity Project and a financial adviser at enableMe. She was formerly a financial journalist and broadcaster.
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With many mortgage rates now below 5%, and the S&P500 having returned almost 16% in the past 12 months, you might be asking yourself the same question.
The first thing to call out is that investing and risk go hand in hand, so the phrase “risk-free returns” is usually an oxymoron – but your mortgage presents a notable exception.
Repaying that debt faster guarantees a return because you don’t have to pay interest on debt you don’t owe. While they say there’s no such thing as a free lunch, this comes pretty close in my opinion – and over time it could be many fancy lunches.
Consider a $500,000 mortgage at an average interest rate of 6% (I’m using this as a proxy for a long-term average, because interest rates will go up and down over the course of a mortgage term).
Over 30 years you’d pay just under $580,000. Over 20 years it’s just under $400,000, over 10 years it’s just $166,000 – which is compelling.
But that guaranteed “return” is not the only benefit. Few things de-risk your financial position more effectively than securing the roof over your head, regardless of what happens to share markets, house prices, interest rates, job security or health events. Just cast your mind back to the recent spike in interest rates and consider how much easier your situation would have been with a smaller mortgage – or no mortgage at all.
Repaying a mortgage early guarantees savings by cutting interest. Photo / 123RF
There is also the argument that creating equity in your home enables you to put that to use in purchasing an investment property, so you can benefit from the capital gains of a property where the interest cost is deductible against the property’s income and rent covers (at least most of) the mortgage. You can also achieve that with a cash deposit, but it’s more tax-efficient for debt to sit against an investment property than a home.
So let’s look at the opportunity cost – if you put extra money on the mortgage, and save yourself 6% in interest, what are you forgoing by not putting it elsewhere?
One argument is liquidity, because it’s easy to sell shares, less so your house. However, some mortgage structures can achieve fairly significant levels of liquidity, so let’s focus on returns.
A 6% return looks meagre up against what the share market is currently delivering – but it’s important to understand that the return you need to beat a 6% mortgage rate is not 6%!
That’s because paying off your mortgage faster is not only a risk-free return, it’s tax-free, and (largely) fee-free. That means the gross return you need to generate elsewhere must be significantly higher to ensure the net return – less tax and fees – still trumps it.
Let me give you an example – bearing in mind it will depend on your tax rate, and the applicable fees.
Let’s say you invest in an actively managed growth fund, which charges fees of 1%. Because the fund is a PIE, the applicable tax rate is what’s known as the Prescribed Investor Rate, and let’s assume yours is the top one at 28c. (If you’ve been able to both purchase a home and have cash to spare to consider this question, I’m assuming you earn over $78,000 a year.)
You’d need your investment returns to be around 9.3% just to match the “return” of paying off a 6% mortgage – more to better it. For a low-fee index fund charging a 0.4% fee, the number to beat is 8.7%. (If investing in shares directly there are more variables, and possibly a higher tax rate to consider).
Of course, what I’m not factoring in here is inflation steadily erodes the “real” cost of debt – but given it also erodes the nominal return on shares (and I have a set word limit!) I’m not factoring inflation in either side.
I mentioned the S&P500 has returned almost 16% in the past 12 months – which is well above those break-even numbers. So, does that put us in “no brainer” investment territory?
To my mind, no.
Cherry-picking a single year’s returns is foolhardy. The long-term average is closer to 10% (pre-inflation), but annual results swing wildly – sometimes down 40%, or up 30%.
I can’t – and I don’t think you should – ignore the risk that investment returns may not outpace your mortgage rate, or that the timing of unfortunate life events may occur when times are good.
It’s easy to say you’re comfortable with risk when your investments are going gangbusters, your true feelings are evident in how you cope when they’re plunging. Plus, what matters more than how you feel about risk is how much of it your situation can actually tolerate.
If you want certainty and a guaranteed “return”, then faster mortgage repayment remains compelling. If you have a robust situation, a stomach for volatility and are young enough to have a long-term investment horizon, then investing alongside debt repayment can also pay off.
Rather than being absolutist one way or the other, there’s often a balance to be found – and in fact mortgage holders who are in KiwiSaver already have a foot in each camp.
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