Pros and cons of paying off the house early

Record low interest rates have impacted a number of personal finance strategies. Borrowing to invest has never been cheaper. Having money in a cash account has rarely been less attractive. And the conventional wisdom that says making extra mortgage repayments is a great financial strategy is, perhaps, on slightly shaky ground.

Let's compare two strategies – making extra mortgage repayments with salary sacrificing to superannuation, to see which creates more wealth over time. Paying extra to the mortgage has long been a reliable personal finance strategy. It has (and retains) the core non-financial benefit that it allows a person to say that they own their house outright, a major financial goal for many people.

The reduction of home loan debt leaves people less exposed to financial pressure when interest rates rise, and more able to cope with financial emergencies like loss of income for a period of time. All of these factors – outright homeownership, a better ability to cope with rate rises and coping better with financial emergencies – make extra mortgage repayments worth considering.

The return from making extra mortgage repayments is the reduction of future mortgage interest. When mortgage interest rates were at 9 per cent (not that long ago), every extra dollar paid to the mortgage earned 9 per cent in reduced future interest payments. This return is tax free (there is no tax paid on the interest saving) and risk free (you know that you are saving future loan interest). A tax free, risk free return of 9 per cent is extremely attractive. With interest rates currently at 4.5 per cent, the return from this strategy is only half as good.

Another reliable personal finance strategy is that of salary sacrificing to superannuation. The key benefit here is saving the income tax. Salary-sacrificed contributions to superannuation are only taxed at 15 per cent on their way into your superannuation fund, compared to the 32.5 per cent plus 2 per cent medicare levy tax rate for income earned for the average income earner – an immediate tax saving. Once the money is in the superannuation environment, it is earning investment returns in the low tax environment of superannuation.

A case study for comparison

Let's use a case study to compare the results for the two strategies. Let's assume that the couple in the case study are 50, consider themselves to be 15 years from retirement and both earn the average full time income of around $75,000. They have a mortgage of $350,000, with a 4.5 per cent interest rate and $0 in fees.

They want to compare two strategies. Strategy one is to make extra mortgage repayments, so that their mortgage is completely paid off by the time they retire in 15 years. Strategy two is to make interest-only repayments on their mortgage for the next 15 years, and use the money they would have used to pay off their mortgage to salary sacrifice to superannuation. At retirement, they will withdraw a lump sum from superannuation (currently a tax free option) and pay off the mortgage.

Strategy one – extra mortgage repayments

According to the moneysmart.gov.au mortgage calculator, the couple will have to pay $2,677 a month toward the mortgage (with an interest rate of 4.5 per cent and $0 fees) for the next 15 years to have reduced the mortgage to $0 at retirement. 

Strategy two – salary sacrifice to superannuation

If they switch their loan to an interest-only option at 4.5 per cent, their monthly repayments fall to $1,312. This means that they have the equivalent of $1,365 of after-tax income to salary sacrifice to superannuation if they choose this as their preferred strategy.

The couple are average income earners, and face a tax rate of 32.5 per cent plus 2 per cent Medicare levy. This means that to make an extra payment to their mortgage of $1,365 per month, they had to earn $2,084 pre-tax. They then paid $719 in tax and Medicare levy, leaving them with $1,365 for their extra mortgage repayments.

This means that they can salary sacrifice the pre-tax amount of $2,084 to superannuation, paying only 15 per cent contributions tax. This equates to only $313 tax, leaving $1,771 to go to work in the superannuation fund. This is the key element of the strategy – they save $400 of tax every month, $4,800 per year or $72,000 over the next 15 years.

Keep in mind that we are talking about a couple, so the $2,084 in monthly contributions will likely be under the superannuation contributions limits even taking into account their compulsory superannuation contributions.

Calculating expected returns in super

Here comes to the challenging part of the calculation – what rate of return do we assume for the earnings on the money in superannuation?  A starting point might be the SuperRatings returns for a balanced super fund. Over the 10 years to the end of July 2015, the average balanced super fund provided an average annual return of 6.48 per cent per annum. Keep in mind that this was hardly a period of ‘plain sailing' in investment markets – it included a nearly 50 per cent fall in the value of Australian shares between late 2007 and early 2009. If the $1,771 monthly after tax contribution to superannuation earned an average annual rate of 6.48 per cent per annum after fees and tax, the superannuation balance from these contributions would have grown to $537,000 over 15 years. At this time (15 years later) there would be plenty enough to pay off the $300,000 mortgage, and enjoy an extra $237,000 left over.

The real challenge here is the 6.48 per cent return – will we get that return in the future? However, an interesting element to these calculations is that even if we assume that we invest all of the money in a cash account earning the current rate of around 2 per cent, which is effectively a risk-free return, we end up with a superannuation balance of $371,000 – still a handy ‘win' for the superannuation strategy.

Last year SuperRatings calculated the average annual return from a balanced superannuation fund in the 22 years of compulsory superannuation to be 7.2 per cent a year. This level of return would have resulted in an ending superannuation balance of around $571,000.

The ASX Russell Long Term Investing Report for the period to the end of December 2014 shows that the 20-year average annual return from Australian shares held in the superannuation tax environment was 9.9 per cent a year after tax. If you were an investor more comfortable with the risk of Australian shares, and were able to achieve these returns over the 15 years, the ending superannuation balance would have been an impressive $727,000.

Conclusion

There are three key assumptions here that mean we should be cautious about any conclusions:

1. We don't know what will happen to interest rates in the future, and this will impact the strategy;
2. We have had to assume some level of investment returns – however we don't know what future investment returns will be; and
3. We have assumed that the legislation around superannuation won't change over the next 15 years – however change around superannuation seems to have been a constant. Taxing superannuation withdrawals, for example, would significantly impact the final outcome.

We live in interesting times, including historically low interest rates. This erodes some of the benefit in the ‘pay off the home loan early' wisdom, with some apparent financial benefit to adopting a salary sacrificing to superannuation strategy. Of course, as individual self-directed investors, we don't need to choose one strategy or the other - using some combination of the two may work well for many people.

Scott Francis is a personal finance commentator, and previously worked as an independent financial adviser. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.