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‘Some problems are so complex that you have to be highly intelligent and well informed just to be undecided about them.’
We don’t know if Canadian writer Laurence Peter was thinking about mortgages and investing when he penned those words – probably not – but he knew what he was talking about.
The truth is, whether or not you should make larger mortgage repayments or put the cash in stocks can only be known with hindsight because the future performance of different asset classes is unknowable. We can make some educated guesses, but the future is always hazy. Broadly, there are five variables that determine the answer: interest rates, investment returns, taxes, your age and risk tolerance.
The reason it’s hard to nail down an answer to the deceptively simple question ‘what should I do with my money’ is that it ultimately depends on the movement of interest rates and investment yields, both of which are unpredictable.
There is one easy decision, though: If you have any high-interest debts, such as credit cards and personal loans, paying these off should be your top priority. Paying off a credit card that charges 20% in interest is the same as getting a 20% return on your savings – or more, after taxes – which would be hard to match even by investing in stocks.
If you have a mortgage that charges 3–6% interest, though, deciding whether to invest or make extra repayments is a harder call. Ideally, you want to put your money into whatever asset yields the most. Let’s imagine that you have a mortgage charging 5% and your marginal income tax rate is 30%. Paying off the mortgage would save you 5% a year, so you would need a return higher than 7% from stocks for it to be worth directing money there in preference.
The stock market has returned around 9% a year over the long haul, although, with the long-term yield on Australian government bonds near record lows, it's likely that future returns from stocks will be lower than that – perhaps as low as 7%. If you’re investing through your super fund, the argument for stocks strengthens a lot.
If you're a high-income earner, your marginal tax rate could be 37– 45%. Salary sacrificed super contributions attract a tax rate of only 15%, which is a huge saving – you essentially have $134–155 to invest for every $100 you would have if investing outside a super account. It’s hard to imagine your super fund contributions not outperforming a 5% mortgage if you’re young and investing for the next 30 years.
Alongside returns, however, you always need to consider risk and here stocks are at a major disadvantage because their returns are uncertain, whereas the savings from paying off debt are guaranteed. If you have a low tolerance for risk or a short time horizon, paying down the mortgage will probably let you sleep better at night.
On top of this, if you’re a low-income earner, your tax rate is probably also low, making super a less attractive option. Low-income earners typically have less wiggle-room when it comes to risk and may not have a large emergency cash pile to act as a safety net. If that’s the case for you, the guaranteed savings from paying off your mortgage probably trumps the higher but more volatile returns typical of stocks.
To sum things up, if you’re risk-averse, a low-income earner, or your mortgage is locked into a high interest rate, it’s probably better to focus on reducing your mortgage. If you’re a high income earner and you want to diversify your assets, building a stock portfolio can make sense – especially if your marginal tax rate is high and you’re investing through Super.
For many people, the answer is probably to do a bit of both – continue paying off your mortgage, but don’t neglect building a nest egg of other assets.
Graham Witcomb is a senior analyst at InvestSMART. To access more share research from InvestSMART, start a 15-day free trial.