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Major mortgage decision for Aussies who don't want to work forever

So often, people get hung up on whether they should pay off their mortgage or invest. Natasha Etschmann and Ana Kresina break down what you should consider.

Natasha Etschmann and Ana Kresina
Natasha Etschmann and Ana Kresina (Supplied)

Not all debts are created equal. Personal loans are often used to purchase items. These items may lose value over time and are therefore known as depreciating assets.

However, taking out a mortgage to purchase property – an appreciating asset that most often increases in value over time – gives you a much higher chance of growing your wealth.

This is an important factor to consider when deciding between paying off debt or investing.

But is it better to pay off your mortgage or invest?

If your mortgage has a high interest rate (say, 6 per cent), and the average stock market return is 7.33 per cent (like the S&P 500 returns over the past 20 years), it may be better to pay off your mortgage than put your money into the stock market.

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Despite potentially higher returns from the market, the guaranteed saving from paying off a high-interest mortgage is significant. Plus, you’ll pay tax on your investment earnings.

With a low mortgage interest rate closer to 2 per cent, investing with the hope of a 7 per cent return seems like a more convincing idea.

The lower interest rate on the mortgage makes the chance of higher returns on the stock market in comparison to the debt a lot higher.

Returns from investments are subject to tax, which will reduce your overall investment gain. This must be considered when comparing potential investing returns to the savings from paying off your mortgage.

Unfortunately, tax can get complicated and the rate varies depending on the income you’ve earned and how long an asset has been held, so there’s no universal rule that works here.

Putting all your money into one share or one property can be risky.

There are both pros and cons, and often there are different considerations – such as whether the property is your primary property of residence (PPOR) or an investment property (IP).

If you choose to pay down your mortgage, you may have ‘concentration risk’, meaning your investments are concentrated in one sector (property) in one area (Australia, or even just one suburb) and are not diversified.

Opportunity cost is the loss of an opportunity when an alternative option is chosen.

If you choose to pay down your mortgage, you may be losing out on higher returns through investing. However, the peace of mind that comes with paying off your mortgage is pretty amazing too.

Weighing up the pros and cons of what your opportunity cost is may help you make the best decision.

Compare your options by looking at the pros and cons of each.

Paying off your mortgage:

  • Pros: guaranteed return in the form of interest savings; reduced financial stress; a sense of security.

  • Cons: potential to miss out on higher returns; overconcentration on one property.

Investing in shares:

  • Pros: potential for higher returns; diversification of assets; potential long-term growth; possible tax deductions.

  • Cons: market risk; tax implications on returns; the possibility of lower returns than mortgage interest savings.

There’s no single answer when it comes to making financial decisions. That’s why personal finance is personal.

Other reasons for not paying off debt

Paying off high-interest debt is not necessarily the right answer for everyone in every situation.

Some loans can be hard to pay off early or exit without paying huge fees, so read your contract carefully and understand how the fees work.

There are a few things you might want to consider when deciding if it’s worth paying off a debt early:

  • Exit fee: a fee charged when you pay off your loan and want to close the account.

  • Early repayment fee: a fee charged when you pay off your loan before a specific time.

  • Tax deduction: having debt is beneficial if, for example, you have a car loan in a business name or you’re negatively gearing.

  • Debt recycling: essentially the process of using your income to pay down your home loan, and then redrawing that amount to invest. This strategy converts the non-deductible debt of your home loan (which doesn’t generate any tax benefits) into deductible debt tied to investments, allowing you to potentially claim tax deductions on the interest of the redrawn amount used for investing.

When it comes to personal finances, you can always run the numbers and have a calculated answer, but there’s also an emotional component to consider.

For example, it might make sense to completely pay off your $1,000-per-month personal loan before investing. But what happens when you finish paying this off?

Going from never investing to investing $1,000 per month may be a huge and uncomfortable step.

Someone who has already been investing smaller amounts while paying off their debt might feel more comfortable and ready to invest the extra $1,000 per month.

Instead, you might start investing $5-$10 a week as you pay down higher interest debt, so you can build the habit and start learning how you feel about and react to market fluctuations.

The right balance between paying off your debt and investing will be unique to your situation, so do what’s most comfortable for you.

Edited extract from How to not work forever by Natasha Etschmann and Ana Kresina (Wiley $32.95), available 26 June at all leading retailers.

Disclaimer: Any information here is general in nature and has been prepared without considering your personal goals, financial situation, or needs. Because of this, before acting on the general advice, you should consider its appropriateness, having regard to your unique situation. You should obtain and review the Product Disclosure Statement (PDS) and Target Market Determination (TMD) relevant to the product before making any financial product decisions. It's also strongly encouraged to seek the advice of a professional financial adviser.