Should You Pay Off Your Mortgage Early Or Invest? Here's The Math On What's Best
Paying off your mortgage quick can help save you thousands of dollars in interest. But before you start chucking money in that direction, you’ll need to consider a few things before deciding whether it’s a smart idea.
We’ll crunch some numbers and discuss whether it makes sense to use your extra cash to pay off your mortgage early or to invest instead.
How To Pay Off Your Mortgage (in 10 Years or less)
Is this realistic, and is it possible given the standard mortgage term is 30 years?
Sure it is.
First, let’s come up with your typical Australian family: two adults and a kid.
You have a $500,000 mortgage on your home with an interest rate of 3% on a 30-year loan term.
You earn $100,000
Your spouse earns $60,000
Together you pay a combined tax of $36,784 and are left with $123,216 in disposable income, which is $10,268 per month.
Based on your level of income, we can expect total family expenses to be around $5000 per month, not including the mortgage repayments. (We got our numbers from the Australian Bureau of Statistics on Household income and expenditure.)
From our mortgage calculator, you’ll be able to work out the monthly repayment to be $2,108.
Now let’s crunch the numbers.
Transfer the entire $3,160 into your mortgage Redraw or Offset account every month (as Extra repayments), and you’re on your way to paying off your mortgage in 9 years 1 month, saving over $180,000 interest in the process!
There’s nothing crazy about this.
You could pay off your mortgage even quicker by sticking to a budget plan. Reducing your monthly expenses from $5000 to $4000 and increasing your extra repayments by an additional $1000 will help pay off the loan in 7 and a half years.
Paying off your mortgage is something we recommend especially if it’s your primary place of residence because you receive no tax deductions from the interest you pay on your owner-occupier mortgage.
Why you shouldn’t pay off your Mortgage
Pay off your loan quickly! Don’t pay off your loan! Which is it?
While it’s advisable to be paying off your Owner occupied home loan as fast as possible, the case isn’t quite as clear cut for Investment property loans.
With investment assets, the Australian Tax Office (ATO) will allow you to claim all related expenses as a tax deduction, this includes investment properties, and it’s mortgage interest expense.
So if you paid $15,000 in investment interest this year, you’ll be able to claim the full amount against any taxable income you may have such as your Rental income, Capital gains or your salary if working in Australia.
Right, so how does all this look like with real numbers?
Using the example above, $500,000 mortgage at 3% interest rate and rental income of $500/week.
You would be making a rental income of $25,480 p.a. and some may think that income tax would be payable. However, the ATO allows you to claim all related expenses as a tax deduction, thereby reducing your taxable income to $1,951 (before tax depreciation).
After accounting for all the tax incentives (depreciation and write-offs), you end up in a negatively geared position, i.e. you pay no tax and instead, start accumulating ‘tax credits’.
Want your personalised cash flow and tax position analysis? We created the ultimate investment property analysis tool, go check it out.
The last point as to why you shouldn't rush to pay off your investment mortgage is so you’ll have more cash in the piggy and the flexibility that comes with it.
If your investment interest rate is 3.5% and your Australian marginal income tax rate is at 32.5%, then we can calculate your effective rate of savings from you paying down your investment home loan.
By putting $10,000 into your investment mortgage, you may think you are saving 3.5% per year or $350 in interest, but on paper, you are only saving ((1 - 0.325) * 3.5%) = 2.36%, after you account for the loss of tax deduction.
So it’s a question of opportunity cost/trade-off.
If you believe you can make more than 2.36% (after-tax) with your money elsewhere, then you should reconsider paying down your investment mortgage.
One popular strategy is to still opt for Principal and Interest repayments (because P&I rates are about 0.20% lower than I/O rates) while using your Offset account as a place to hold your cash until a better investment opportunity arises.
An important note to make is that paying down the loan (investment or otherwise) carries almost no risk. Whereas if you intend to buy stocks with the expectation of 10-20% return, there’s most certainly risk involved. It’s a good idea to speak to your financial planner to discuss if it’s sensible before making any big decisions.
Paying off your mortgage early can save you a great deal of money in the long run for relatively little risk. Even a small monthly contribution can allow you to own your property sooner.
However, it may not always be the best option if the mortgage relates to an Investment purpose, and further thought is required.
Regardless, it’s prudent to have an emergency fund before you put your money toward your home loan. Also, pay down your high-interest debts first (e.g. credit cards, personal loans) before you focus on your mortgage.
Making extra payments, refinancing or switching your repayment schedule are all strategies that you can use to pay off your mortgage early if that is your goal.