Home owners with mortgages and a bit of extra cash are faced with an interesting choice: Do you pay off your home loan faster or invest in shares?
Those aren't your only options, of course. You could put your money in your super fund instead or do any number of things. But there are many ways to invest spare cash and it is a popular option.
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. It's about choosing between the certainty of being debt-free versus the potential gains of a successful investment.
Plus, with interest rates hovering at historic lows, it’s plain to see why many borrowers are paying off their mortgage faster.
Option 1: Paying off your mortgage first
Focusing on meeting your mortgage repayments and using useful features including the ability to make extra repayments or an offset account can help you minimise your interest costs. Paying off your mortgage also means you are building equity. And equity is wealth.
Paying off your mortgage has the following benefits and drawbacks:
Pros of faster mortgage repayment
- Minimise interest payable. The faster you repay your loan the less interest your lender can charge you. Repaying your home loan faster gets you out of debt sooner and saves you money.
- Guaranteed return. If you are making extra repayments on a home loan with an interest rate of 2.5%, you are effectively getting a 2.5% return (tax free). Making additional repayments is similar to generating an after-tax return equal to the interest rate of your home loan. This return is smaller in relative terms when interest rates are low than when rates are higher.
- 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 wellbeing.
- 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.
Cons of faster mortgage repayment
- Lack of diversity in your portfolio. 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. It is unlikely that your property will lose value. But it is technically possible, especially if you purchase a home 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.
Option 2: Invest any spare cash in shares
Conventional wisdom might say pay your debts as soon as possible, but low interest rates and the potential for high investment returns mean you do have other options.
While investing in shares comes with risks, if an investor beats their current mortgage repayment rate after tax they will come out ahead. Currently interest rates are around the 2 to 3% mark for most borrowers. But the ASX has a long-run average of between 8 to 10%. You could make more in the share market than you could save through your mortgage (keeping in mind that returns are never guaranteed).
Whether or not you choose to invest will ultimately depend on your personal life situation, how much of your mortgage you've repaid and your appetite for risk.
Pros of investing
- 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.
- 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.
Cons of investing
- 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.
- 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.
What do the experts recommend?
Kylie Purcell, Finder's senior investment editor, offers the following insights:
"This is no easy question to answer. Whether you choose to pay off your mortgage sooner or invest your money elsewhere comes down to your own personal circumstances.
"There are a couple of important things to consider here. First, how much money are you losing by not paying off more of your mortgage i.e. what's your interest rate? Then how much could you earn if you invest it into the stock market? Then, it's just some simple maths.
"As a general rule, the stock market returns around 9% per annum over many years. So if your mortgage rate is say 3%, it would make more sense, from a profit vs loss standpoint, to invest.
"But just doing the maths doesn't take into account the whole situation. For example, how many years left do you have to pay off your mortgage before you can stop working? Would you feel more comfortable paying off your debt sooner? Are you ok with stock market volatility?
"Whatever decision you make, it's a very personal one. There is no right or wrong choice here – just the best choice for you. For long-term planning, it always pays to speak to a financial advisor."
Which option is right for me?
Only you can answer this question for yourself. But here are some tips to help you work it out:
- Talk to a financial planner. Why not let an expert guide you through your options and show you how to get more out of your money?
- Consider your lifestyle stage. 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.
- What's your risk tolerance? How much, if any, can you afford to lose? 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.
- Do you have other debts to worry about? A home loan is one of the lowest interest rate debts you'll ever have. But if you have debt from a credit card or a personal loan you should focus on paying those off before worrying about investing or extra repayments. You can reassess once you are free of high interest debts.
More options for your money