When compared to shares, paying off your mortgage is likely to come out on top when unlocking guaranteed return, peace of mind and financial security.
It’s the mortgage vs shares debate.
Deciding where to channel your money is a personal decision that depends on your lifestyle and homeownership goals, your marginal tax rate, and your risk tolerance.
Although the financial return (compounded effect) and accessibility of shares can be an attractive asset class for many individuals, Australians have always been partial to paying down their mortgage and owning their home outright -- and there’s a good reason why.
Focusing on meeting your mortgage repayments and using useful features including the ability to make extra repayments and an offset account can help you minimise your interest and build equity over time which can boost your wealth position.
Plus, with interest rates hovering at historic lows, it’s plain to see why many borrowers are paying off their mortgage faster. However, it’s still worth investigating the benefits and risks of investing in property versus shares to ensure that you make a decision that’s within your best financial interests.
Paying off your mortgage
Using your extra cash to make additional mortgage repayments can not only save you thousands of dollars in interest, it can also help you repay your loan sooner.
Generally, focusing on paying down your mortgage has the following benefits and drawbacks:
- Minimise interest payable. If you have funds sitting in a linked offset account, you can reduce or offset the interest payable on your home loan by the amount held in the account. An offset account can also help you shorten your loan term, as you’ll be able to repay the loan sooner. For instance, if you had a 100% offset account with $50,000 on a mortgage of $300,000, your interest would be calculated on a balance of $250,000 (instead of $300,000). On a home loan of 5.50% over 30 years, this could amount to a saving of $90,000 in interest. You would also shrink your loan term by seven years. The offset account effectively earns a high interest rate and is free from income tax, it also allows you to withdraw funds as you see fit (however you should practise caution if you decide to do this).
- Guaranteed return. If you are making extra repayments on a home loan with 5.5%, you are effectively getting 5.5% return (tax free). Making additional repayments is similar to generating an after-tax return equal to the interest rate of your home loan.
- Financial security. Paying down your home loan can make sense in an environment where there is volatility and uncertainty in the share market. Repaying your home loan and owning your property outright can give you peace of mind in knowing that you will have a roof over your head. As mortgage repayments will likely comprise a large portion of your expenses, eliminating this financial obligation sooner will improve your quality of life and your financial well being.
- Build equity. Another advantage of investing in property over shares is that you can borrow against your equity to purchase other investments and diversify your portfolio.
- Strategy risk. Although you can benefit from the tax effectiveness of paying down your home loan quickly, you are concentrating your wealth into one asset which can be a risky strategy due to the lack of diversification. This means your wealth is tied up in the residential property market and thus you could be vulnerable to a downturn in the market.
- Property depreciation. While you may anticipate that your property value will appreciate over time, there is a chance that the property may depreciate in value (especially if you purchase in a suburb that is dependent on one industry or an area where supply exceeds demand) . This can lower the amount of equity that you have which can harm your financial liberty.
- Opportunity cost. Another drawback to paying off your home loan rather than investing in shares is the opportunity cost you face. You could be missing out on high investment returns from shares. For instance, if the return on certain shares is 8% and the interest rate on your mortgage is 5.5% you could be forgoing a higher return.
Paying less off mortgage and investing in shares
Deciding to diversify your wealth across both the residential property market and shares can be a good strategy, but just be mindful of the associated advantages and risks.
You need to consider the kind of return you want from your shares for it to be a better strategy compared to paying off your mortgage.Generally, the rate of return on your investment would need to be higher than the interest rate on your home loan. If you’re thinking of investing in shares, you would also need to consider the marginal rate of tax being used.
Depending on your personal situation and the state of the market, some financial advisers say that once you have 50% of equity in your property, you can start thinking about investing your money in other areas, such as shares.
If the only debt you have is your mortgage, and you have extra cash after meeting your minimum mortgage repayments, then you may want to consider making extra repayments on your mortgage and also investing in a share portfolio.
However, be wary of market fluctuations and the tax implications of investing in shares.
- Investment return. Shares have the potential to provide potential income in the form of dividends over an extended period of time. If you can earn more by investing in the share market than you would save in interest by paying the same amount into your mortgage, then it could make sense to invest in shares rather than to pay down the mortgage. For example, if you have a home loan rate of 5.0%, it might be wise to make a long-term investment that will provide a 8% return. This would provide you with enough additional income to finance your home loan repayments.
- Diversification. Diversifying your wealth across different asset classes such as your home and shares can offer increased diversification. Although you won’t be paying down your mortgage as quickly, you will still be paying down your principal and interest repayments while also building up a portfolio of shares. A diversified strategy can protect you from poor performance in a given market.
- Compounding. If you invest your money, you can benefit from long-term financial benefits (such as capital gain) achieved through compounding. To maximise the benefits of compounding, it is important to allow time for an investment to grow. Generally, you can benefit from lower tax rates on long-term capital gains.
- Accessibility. Investing in shares can be more accessible than investing in property. If you don’t have enough savings for a 20% deposit (to avoid paying lender’s mortgage insurance), you can build a share portfolio for a small upfront cost, such as $10,000, which can provide you with regular income in the form of dividends.
- Market fluctuations. Investments exposed to the share market are subject to market fluctuations. It’s essential that you take a long-term approach and speak to a financial adviser to ensure that you can cope when the market is underperforming. Don’t rely too heavily on dividend income as this may vary significantly from month to month. Remember that share prices for a company can fall sharply and your dividend payment can change drastically.
- Strategy risk. Investing in shares can be risky due to the unpredictable nature of the share market which is why it’s worth seeking professional advice before initiating this strategy. If the company goes into the red, you may not get your money back.
- Income tax. Shares and managed fund assets are subject to income tax on any distribution or dividends, plus capital gains tax (CGT) may apply when you sell the assets.
- Experience level. Investing in shares takes time, research and analysis. You need to keep an eye on the market, economy and company performance to ensure that you are monitoring your risk. To minimise your risk, you often need to be an experienced investor.
Anything else I should consider?
- Lifestyle stage. When deciding whether you should focus on paying down your mortgage or if you should invest in shares, you should review your financial and lifestyle goals. Do you want an asset that increases in value and provides a secondary income source, or would you prefer to own your home outright? Or do you want both? Do you value peace of mind or potentially higher returns? It’s worth noting that if you’re nearing retirement or you have a young family, you may want to focus on repaying your mortgage.
- Risk tolerance. All debt comes with a degree of risk so it’s important to factor this into your decision-making when deciding where you should allocate your extra cash. Generally, the higher the return, the higher the risk. Always speak to the experts to make sure your minimising your risk where possible.
- Prioritise high-interest rate debt. You should look to repay your most expensive debt first, such as your personal loan or credit card, as this will have a higher interest rate attached compared to your mortgage. So if you have several debts, you may want to prioritise paying these off before paying down your mortgage or investing in the share market.