How to choose between super and the mortgage

Sustained low interest rates have certainly made paying off the mortgage easier in recent years. But they have also given a boost to a combined super/mortgage strategy.

Those in their 50s often ask if they should accelerate repaying the home loan, or direct spare funds to super.

Usually, it’s best to do both. However, with interest rates as low as they are at the moment, it can pay to reduce your mortgage as little as possible and shovel as much as you can into super.

In essence, a strategy that would work for many Australians would be to switch home mortgage repayments to interest only. Then, salary sacrifice the savings from the reduced home loan payments into superannuation, meaning you are paying lower overall tax and getting more into super. Then, when you have turned 60 and can start to access your super tax free, access enough to pay out your home loan.

Isn’t that just a nil sum game money merry-go-round?

No, it’s not. Let’s look at an example.

Let’s take a 50-year-old employee earning $100,000 a year. She’s got $120,000 left on her mortgage, at an interest rate of 5% (which is fairly standard now), which is the remainder of a mortgage of $300,000 taken out 15 years ago.

Mortgage repayments are approximately $21,050 a year ($1754 a month) on principal and interest.

If the mortgage were switched to interest only for the remaining $120,000, repayments would be $6000 a year. That has freed up $15,050 a year, after tax. Before tax, our 50-year-old had to earn $24,672 in order to finish up with $15,050.

If she were now to salary sacrifice that $24,672 into super, it would only be taxed at 15% (rather than 39%), or $3700.80, leaving $20,971.20 to stay in the super fund.

Already, she has saved paying $5921 in tax – the difference between her marginal tax rate of 39% and the super contributions tax of 15% – which is in her super fund earning for her.

How much extra is in a super fund after 10 years of implementing this strategy? I’ll make an assumption of investment returns of a flat 7% and will reduce earnings in the fund by an average tax rate of 12% (though trustees of SMSFs have a little more control over their tax than those in regular super funds).

Her super fund now has nearly an extra $300,000 in it. Having just turned 60 and retired, she can draw the $120,000 extra to repay the outstanding home mortgage. She still has an extra $180,000 in super.

However, we need to reduce that $180,000 further as there would have been savings for the mortgage having been paid down. But it would still leave somewhere north of $165,000.

This strategy makes far more sense when interest rates are low. It would also be significantly improved during periods when investment returns are higher (as they have been in recent years). But to take that out, I have used 7%, which should be a longer-term return for, say, a balanced fund.

Obviously, if investment markets are falling, then this strategy can struggle to make sense, but that is also why I have used a 10-year time frame.

How is this extra money magically created? It’s partly to do with the lower taxation of the salary sacrifice into your super.

Over 10 years – assuming only CPI increases in salary – there is nearly $60,000 of money that would have otherwise been paid in tax sitting in the super fund. That money will have been earning at a compound rate and will be taxed at super tax rates of 10% or 15%.

Another reason is the extra contributions to super, which are invested in a low-tax environment.

And there’s the higher return. Paying down the home loan earns you 5%, a rate which is at historical lows. Superannuation over the longer term should earn you more than that and I’ve used 7% in this example (though in the last two years, it has been significantly higher).

During periods of higher home loan interest rates, the figures quickly reduce the effectiveness of this strategy.

There is a real sweet spot for this strategy, and it’s for those earning between about $100,000 and $160,000, where they have the ability to make considerable additional contributions to super.

Those earning more than $180,000 can still benefit, but it gets a little harder, partly because your super contributions from your employer are higher. If you’re earning $200,000 a year and your employer is putting in the 9.5% superannuation guarantee payment, then you already have $19,000 going into super, with a maximum of $16,000 you could contribute through salary sacrifice.

In general, the lift in the current concessional limit to $35,000, which came into force for the over-50s from July 1 this year, has meant this strategy has become far more appealing again. (The concessional contribution limit is only $30,000 for the under-50s.)

But it won’t work well for everyone. It works best for those in middle income brackets. Here, the tax saving from salary sacrificing is still significant enough to make the strategy work.

The move in recent years to lift the bottom tax rate from 30% to 32.5% has meant that the strategy works a little better than it used to for lower income earners also.

If the strategy appeals to you, get professional advice to help fine tune the strategy to make the most of your situation.

The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.

Bruce Brammall is director of Castellan Financial Consulting and the author of Debt Man Walking. E: bruce@castellanfinancial.com.au

• The SMSF Professionals’ Association of Australia has hit back at critics of trustees’ asset allocations. “"In recent days we have been told trustees are overweight in Australian equities, especially the fully franked blue chips such as the banks and Telstra,” director of technical and professional standards Graeme Colley said. "It wasn't so long ago these same critics were pointing their fingers at SMSFs for holding too much in cash and fixed deposits.”
• SMSF audits could become fully automated if technology improves enough, a SMSF technology consultant says. “I do think that’s going to be quite possible, but we’re talking [in] a timeframe a fair way away,” he said, according to media reports.
• Nationals Senator Matthew Canavan says retirement savings should be available to first home buyers. “I've suggested we allow people to access their superannuation to buy their first home, I think it's very important we allow people to do that and it's their money and they should have control of it,” he told reporters.