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Should I make additional mortgage repayments or start investing?

Jul 29, 2020

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

  1. What is the right thing to do? Depends on your goals and financial position – one strategy isn’t right for everyone
    1. Someone in their 20s – may be better to invest – have long timeframe for funds to grow -
    2. Someone in their 50s – may be better to pay debt
  2. First step is to look at your overall levels of debt –
    1. Not talking investment debt here – but bad debts – the non-deductible debt – costs cashflow and has a negative compounding return from the interest
    2. Also depends on how much debt you have and your LVR – if you have no savings – better to save a little before investing
    3. 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 –
      1. Put yourself back into an 80% LVR – protect from the bank coming for your house if values went through a massive decline
      2. 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
    4. 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

  1. Question - What is the minimum benchmark for opportunity costs?
  2. You want your money to work for you – so need to price it into the equation –
    1. Little point saving at the moment beyond having enough in emergency funds
  3. 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
    1. Interest costs versus return potentials
    2. Interest costs are to your income only – Debt levels don’t grow
    3. Investment returns also change – have an income level but also growth –
  4. Have to take into account the potential for inflation –
    1. Inflation is your friend if you have debt
    2. Inflation is not your friend if you have cash savings or an investment
    3. Both situations eats away the real returns
  5. Current situation – Low interest rates, low inflation, uncertainty in the markets –
    1. But any strategy is long term – but has to adjust over time –
    2. The long term outcomes focus here – given in your 30s – long term game – mortgage has a 30 year timeframe

Looking at the options -

  1. Investing – two options here - Personal or super through salary sacrifice
    1. Personal investing – would need to select funds that can be invested on a monthly basis
      1. Or alternatively – save up lump sums against your mortgage in an offset account and then invest once you reach a level
    2. Salary Sacrifice – put funds into super pre-tax – would gross up the level overall - depends on your own personal income
      1. 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
      2. 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
    3. Extra Mortgage repayments – Offset accounts versus paying down the mortgage
      1. Lets say that you have an interest rate of 3.5% p.a. on the $580,000 – total repayments of $2,608 p.m.
      2. 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.

  1. 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
  2. Investing in a fund – gets 8% p.a. on average – put in $2k p.m. – same time period of 13.5 years (162 months)
    1. Total investment value is $584,112 - however similar to the mortgage you have contributed funds –
    2. Contributed funds is $324,000 - The growth in assets is $260,112
  3. So the difference – interest saved versus the growth of the investments
    1. Interest of $212,805 versus growth of $260,112 = $47,307 in additional value

But what happens after this?

  1. 14 years’ time – you have a mortgage paid off – or around $400,000 left on the mortgage if you keep making the minimum repayments
    1. Now you have another choice – keep investing or make additional debt repayments
  2. 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.
    1. Investing in 14 years at greater level = $1,897,510 in 30 years
      1. Taking into account the interest saved of $212,805 – total value is $2,110,315
    2. Or keep on the original path by making $2k p.m. = $3m invested
    3. So almost a $900k difference over 30 years
  3. Present value of situation – assuming inflation of 2.5%
    1. Repaying mortgage then investing = $897k
    2. Investing along the way = $1.42m
  4. Passive income point of view – assuming a 5% income yield off the investments
    1. Income of $150k versus $95k – both scenarios the mortgage is paid off and one has a higher income –
    2. Assuming no super here – which would boost the income on top of this
    3. Over 30% more income personally

So what is best? Based around the numbers – investing

  1. As long as you have enough in the offset or LVR is low enough – investing
  2. A lot of it comes down to individual situation and preferences
    1. 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

  1. 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
  2. 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

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