More sense to invest in super than the mortgage
By Annette Sampson | theage.com.au | 04 July
Pay off your home loan first. It's motherhood advice that has long been passed on from one generation to the next. Like "brush your teeth every night" and "be kind to your mother", it's advice that's solid and reassuring. Whatever else Mum and Dad may have got wrong, you can be sure this is right.
Well, maybe. The last round of super changes was such a good deal this is no longer a black and white issue. For those who can claim a tax deduction on super contributions (either through personal deductible contributions or sacrificing part of their salary as a trade for higher employer super contributions), it is such a good deal that, all else being equal, it may make more sense to keep the home loan and pump money into super instead.
The executive director of Macquarie Adviser Services, David Shirlow, has compared the tax benefits of three popular investment strategies: salary sacrificing into super, borrowing to invest, and paying off the home loan. In each case he assumed a 10-year time-frame and that the investor can withdraw the super benefit tax-free. The graphs show which strategy fares best for the main tax brackets at different investment returns and interest rates on the home and investment loans.
What is striking is that at all three major tax rates (31.5, 41.5 and 46.5 per cent including the Medicare levy), paying off the home loan makes most sense when returns are lower. That seems to be because "earnings" on the growth in your home are totally tax-free whereas some tax is payable on both super and investment portfolios.
But because you have to make your home loan repayments from after-tax money, you do not get the upfront tax bang for your buck that you do with super and gearing - both of which can generate an immediate tax advantage. So these strategies gain in benefit as investment returns increase.
As you might expect, paying off the home loan works out best in more circumstances for those on the 31.5 per cent tax rate (which will apply on all income from $34,000 to $80,000 from July 1), whose dollar is worth more after tax than those on higher tax rates. For those still paying the top marginal tax rate, paying off the home loan only fares best in times of higher interest rates and lower returns.
For gearing to come out on top, you need lower interest rates and higher returns. That is not surprising, as gearing can only be justified if your investment returns are higher than your after-tax interest costs.
Interestingly, gearing wins out under a wider range of scenarios for those on lower tax rates. This defies the old assumption that it only works for high earners who get the biggest benefit from the tax deduction on their borrowing costs.
Shirlow says gearing is more attractive to lower earners because of lower tax rates, and the fact that only 50 per cent of any capital gains are taxed if the investment is held for at least a year. His modelling has assumed 20 per cent of the investments are turned over each year and warns the results could be less compelling if the investor only sold at the end of the 10-year period when a larger capital gain could push them into a higher tax bracket. But by taking up the middle ground, super comes across as an attractive option. It fares best under a wider range of circumstances as your tax rate increases, but even at the 31.5 per cent rate it is the preferred strategy for Macquarie's long-term projection of investment returns of about 7.3 per cent after fees and interest rates of about 9 per cent.
Of course, deciding which strategy will work for you will not depend solely on its tax advantages. Borrowing to invest is riskier than paying off your home loan or investing in super. Neither super nor gearing can provide the sense of security that owning your home outright can deliver. And, for all its benefits, super has limitations. You cannot access your money until the age of 55 and you have to wait until 60 before you can withdraw super benefits tax-free. So what you win on tax-effectiveness, you lose on flexibility.
But if you are serious about making the most of your investment dollars, it is worth doing the sums. Paying off your home loan is certainly a good strategy, but it may not be the best one.
Interestingly, gearing wins out under a wider range of scenarios for those on lower tax rates. This defies the old assumption that it only works for high earners who get the biggest benefit from the tax deduction on their borrowing costs.
Shirlow says gearing is more attractive to lower earners because of lower tax rates, and the fact that only 50 per cent of any capital gains are taxed if the investment is held for at least a year. His modelling has assumed 20 per cent of the investments are turned over each year and warns the results could be less compelling if the investor only sold at the end of the 10-year period when a larger capital gain could push them into a higher tax bracket. But by taking up the middle ground, super comes across as an attractive option. It fares best under a wider range of circumstances as your tax rate increases, but even at the 31.5 per cent rate it is the preferred strategy for Macquarie's long-term projection of investment returns of about 7.3 per cent after fees and interest rates of about 9 per cent.
Of course, deciding which strategy will work for you will not depend solely on its tax advantages. Borrowing to invest is riskier than paying off your home loan or investing in super. Neither super nor gearing can provide the sense of security that owning your home outright can deliver. And, for all its benefits, super has limitations. You cannot access your money until the age of 55 and you have to wait until 60 before you can withdraw super benefits tax-free. So what you win on tax-effectiveness, you lose on flexibility.
But if you are serious about making the most of your investment dollars, it is worth doing the sums. Paying off your home loan is certainly a good strategy, but it may not be the best one.
First published by TheAge.com.au on July 04 2008
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