Should I make additional mortgage repayments or start investing?

Welcome to Finance and Fury, the Say What Wednesday edition.

This week’s question is from Scott:

“Hi Louis,

I am currently in my 30s and have recently bought my first home. I would like to get your view if I should take advantage of low interest rates and start to put additional funds into my mortgage or if I should be thinking long term and investing instead. My mortgage is around $580,000 and I would like try to get this paid off as soon as possible but at the same time, know that investing could put me in a better position. Would love to get your thoughts on this.”

Great question - Invest or pay off debts –

This episode is general in nature - This isn’t personal advice – look at the pros and cons of paying off debt versus investing – look at the opportunity cost of each situation

What is the right thing to do? Depends on your goals and financial position – one strategy isn’t right for everyone Someone in their 20s – may be better to invest – have long timeframe for funds to grow - Someone in their 50s – may be better to pay debt First step is to look at your overall levels of debt – Not talking investment debt here – but bad debts – the non-deductible debt – costs cashflow and has a negative compounding return from the interest Also depends on how much debt you have and your LVR – if you have no savings – better to save a little before investing Example – if you have bought your PPR for $600k – but have $550k of mortgage on this – might be worthwhile to focus on debt repayment for a little while – Put yourself back into an 80% LVR – protect from the bank coming for your house if values went through a massive decline Also – have the potential to refinance for a better rate – sometimes banks can give you a worse rate if you are seen as too much risk Say you are on a decent interest rate and have an LVR of below 80% - what is best to do

Concept of hurdle rate – this changes over time – based around interest rate movements versus long term return potentials

Question - What is the minimum benchmark for opportunity costs? You want your money to work for you – so need to price it into the equation – Little point saving at the moment beyond having enough in emergency funds So what is your opportunity cost for your money? Say it is 5% p.a. – then mortgage repayment at the moment is below this level Interest costs versus return potentials Interest costs are to your income only – Debt levels don’t grow Investment returns also change – have an income level but also growth – Have to take into account the potential for inflation – Inflation is your friend if you have debt Inflation is not your friend if you have cash savings or an investment Both situations eats away the real returns Current situation – Low interest rates, low inflation, uncertainty in the markets – But any strategy is long term – but has to adjust over time – The long term outcomes focus here – given in your 30s – long term game – mortgage has a 30 year timeframe

Looking at the options -

Investing – two options here - Personal or super through salary sacrifice Personal investing – would need to select funds that can be invested on a monthly basis Or alternatively – save up lump sums against your mortgage in an offset account and then invest once you reach a level Salary Sacrifice – put funds into super pre-tax – would gross up the level overall - depends on your own personal income Or if you are in a low income bracket – or a partner or spouse is – below the $38k p.a. level – can place in funds to super as a non-concessional - $1k gets the $500 bonus But super would only be an option if you are either getting closer to retirement or don’t mind going without the funds until preservation age – so would by 20+ years Extra Mortgage repayments – Offset accounts versus paying down the mortgage Lets say that you have an interest rate of 3.5% p.a. on the $580,000 – total repayments of $2,608 p.m. Interest costs of repayments would be $1,692 p.m. – total interest cost of $356,600 over 30 years

Examples – Say you have spare cashflow of $2k p.m. = $24k p.a.

Mortgage repayment – put $2k p.m. onto the loan – reduce your mortgage down to about 13.5 years from 30 year period - you would save $212,805 in interest Investing in a fund – gets 8% p.a. on average – put in $2k p.m. – same time period of 13.5 years (162 months) Total investment value is $584,112 - however similar to the mortgage you have contributed funds – Contributed funds is $324,000 - The growth in assets is $260,112 So the difference – interest saved versus the growth of the investments Interest of $212,805 versus growth of $260,112 = $47,307 in additional value

But what happens after this?

14 years’ time – you have a mortgage paid off – or around $400,000 left on the mortgage if you keep making the minimum repayments Now you have another choice – keep investing or make additional debt repayments Say from the 14 year mark – if you have your mortgage paid off – you can put $4,608 into an investment now that your mortgages are paid off – or the other scenario – you don’t have the mortgage paid off – keep making the $2k p.m. Investing in 14 years at greater level = $1,897,510 in 30 years Taking into account the interest saved of $212,805 – total value is $2,110,315 Or keep on the original path by making $2k p.m. = $3m invested So almost a $900k difference over 30 years Present value of situation – assuming inflation of 2.5% Repaying mortgage then investing = $897k Investing along the way = $1.42m Passive income point of view – assuming a 5% income yield off the investments Income of $150k versus $95k – both scenarios the mortgage is paid off and one has a higher income – Assuming no super here – which would boost the income on top of this Over 30% more income personally

So what is best? Based around the numbers – investing

As long as you have enough in the offset or LVR is low enough – investing A lot of it comes down to individual situation and preferences If you have 30 years and time on your side – helps to get the most into investments now to grow over time

Hypothetical – say interest rates kick back in – goes up to 5% - obviously interest payments would go up

Interest costs would go to $540k for the life of the loan – up from $356,600 – so making additional repayments – would save $332k as opposed to $212k Say interest rates go further – The break even for hurdle rate would be around the 7% to 8% p.a. mark -

Shouldn’t be set in stone – have to be flexible to the world around us – but at this stage – monthly investing based around some illustration examples would provide a better long-term outcome

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/