If you have a mortgage and you’re managing to save a bit each month, then you’ve probably pondered this question already and wondered what to do – should I invest or pay the mortgage off early? The traditional advice has always been to focus on reducing debt first and foremost, before investing. But given todays ultra-low interest rates and inflation, does this advice still hold? The truth not as clear-cut as you might think.
Your first reaction might be ‘I want to get out of debt’. And thats a good instinct! We all fantasise of the classic kiwi dream of owning our own mortgage-free home. Being chained to mortgage repayments for the next 25 or 30 years is pretty confronting and if there’s a chance we can shave a few years off then you’ll probably take it right?
Let’s look at the pros and cons of each approach…
Mortgage-free home ownership offers peace of mind
For many of us, owning our own home offers benefits that money can’t buy. Especially for those who are close to retirement, eliminating that monthly mortgage repayment can be a mental relief when faced with an income dependent on superannuation rates – particularly if you don’t have a big retirement fund balance to help it go further. Removing the stress of owing money to the bank can be a real weight off your shoulders, particularly when you’re getting close to the point of wanting to retire.
Being mortgage-free helps your cashflow during later years
Ever thought about how much your weekly budget will be closer to retirement? Your mortgage repayment is likely your biggest bill, but if you eliminate it, you can live on far less. This gives you the flexibility to cut down to part-time work, take a lower-paying job, leave the workforce to start a business or retire early since your expenses are lower.
Reducing your mortgage means increasing equity in your home
By paying down your mortgage, you build equity. Even if you decide to move house, you won’t have to worry about your home being worth less than you owe. This makes it quite a risk-free option for those that are risk-averse.
Reducing your mortgage saves on interest payments
When decide to pay more than your monthly mortgage obligations you’ll save on interest. On a $700,000, 30-year mortgage at 5 percent interest (assuming this stays constant), if you pay just an extra $200 per month you’ll pay the loan off 3 years earlier, and save approximately $81,600 in interest cost (this was calculated using sorted.org.nz’s mortgage calculator). Making larger payments than required each month can pay off your loan much faster than required – assuming your mortgage is structured appropriately and you don’t incur any early repayment fees by your bank. Paying your mortgage off more quickly delivers you an effectively guaranteed benefit, which you can think of as a rate of return (tax free!), in the form of reduced interest costs!
So some compelling reasons to pay down debt more quickly. What about investing that excess income instead?
Investing can help create flexibility
Having a well-diversified set of investments in liquid assets can offer flexibility and control if something unexpected happens. Unforeseen medical expenses or an emergency trip overseas can put us under financially and a lot of people don’t have a fund to cover such unforeseen expenses. An emergency fund should be part of a complete financial plan; usually these funds should be kept in low-volatile, low risk investments. Revolving mortgages or mortgage offset accounts can serve a similar purpose, but they come with their own risks: they usually carry a higher interest rate (and often fees), and in many cases they can be called in – cancelled – by the lending back on short notice – when you might need it most.
Investing helps you learn about and become more comfortable with money
As the (praphrased) saying by Albert Einstein goes: ‘the only source of knowledge is experience’. Being exposed to financial assets such as shares and stocks opens up a world of knowledge and is a great way to build financial skills. For most of us, KiwiSaver is the extent of our investment experience – even though a large majority of people aren’t aware which funds we are invested in. Even small amounts invested in a good quality managed fund, or a little bit invested through Sharesies, can help build interest and engagement in your finances. It’s a great idea for kids, too – the earlier one starts learning, the better!
Investing outside your home helps diversify you
A great benefit of investing your hard-earned cash is that you’ll be diversifying your net wealth outside of just property. The key benefit of diversification is that it helps to reduce risk in your investment portfolio. While you house may be a home first and an investment second, it’s a reality that a large portion of many New Zealand families wealth is tied up in their house. Diversifying – even a small amount – can help build a buffer against volatility in markets.
Investing outside of property can improve returns
The New Zealand sharemarket is at record highs in 2019. This is partially due to record-low interest rates; as debt prices have fallen, investors have poured money into higher-returning asset such as shares. Over the long run, shares have generally outperformed other investment classes, including property. And with interest rates at current levels it’s entirely feasible for a well-balanced equity portfolio to earn a higher post-tax return, over the long run, than you’d pay in interest costs on your mortgage. This is, in effect, gearing a share portfolio – just be aware that it comes at a much higher level of risk.
Debt can improve your investment returns
Property in New Zealand is a highly tax-efficient type of asset to own as an investment. Favourable capital gains rules; offsetting of interest and other expenses, such as rates and body corporate fees; deduction of costs such as property management fees; they all contribute to property becoming a firm investment favourite in New Zealand. Keeping a certain level of debt (known as gearing) on investment property can further improve this tax efficiency and can also increase your returns when house prices increase. The flip side is that gearing can amplify your losses too! And don’t just take our advice – particularly if you’re a property investor, when you’re choosing between investing and paying off your mortgage sooner, make sure you speak with an accountant first.
Invest or pay off the mortgage early?
Ultimately the decision whether to invest or pay the mortgage off early comes down to personal circumstance, financial goals and your tolerance for risk. If you’ve got moderate goals, feel uncomfortable with a big mortgage, and are fairly risk adverse, then perhaps focus on the mortgage. On the other hand, if you’ve got good excess income and stable cashflow, have big financial ambitions, and are reasonably comfortable with a higher level of volatility, then taking on a higher level of risk might be appropriate for you.
One thing your should definitely do before thinking about investing is to make sure you’re consumer-debt free first. Repaying high-interest credit cards, personal loans, and hire purchases should always be prioritised ahead of investments. When you’re considering whether to invest or pay off your mortgage and other debts faster, getting solid advice from an Authorised Financial Adviser is a key step on the road to financial freedom. Take control of your financial future today. It’s easier than you think, and an initial chat with us is free of charge.