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What is the best use of your extra savings? Is it better to make extra mortgage repayments or should you contribute to super to boost your retirement savings?
Usually, the questions don’t end there. You may also need to consider how interest rates may affect your decision. Does it depend on your age? Which strategy will leave you in a better position overall?
As a lawyer might say – it depends! It depends on your personal circumstances, with the factors below among the most important to consider when determining how to make the most of your extra savings.
Factors to consider
- Sense of security you feel when you pay off your mortgage: Perhaps the most common reason to repay a mortgage quickly is the sense of security in knowing it will bring you closer to being debt free. As the interest payments on a home mortgage are not tax deductible (as opposed to investment properties), it is tempting to repay your mortgage as soon as possible. However, it’s important to consider other practical factors too. For instance, there is no tax benefit in making extra mortgage repayments whereas it’s likely there will be a tax benefit in making salary-sacrifice super contributions depending on your marginal tax rate.
- Your mortgage interest rate: Mortgage interest rates are watched very closely in Australia by homeowners as any movements in rates affect their household savings. The higher the interest rate, the higher your mortgage repayments and vice versa. So, in a low interest rate environment, households can save more and can potentially invest their savings or contribute to super. However, in a high interest rate environment, household savings reduce, thereby reducing their ability to invest or contribute to super. This also depends on your stage of life. We discuss this further in the case studies below.
- Time left until you expect to retire: There are certain conditions of release you must meet before you can access your super. Most people are eligible to access their super between ages 60 to 65. While making extra contribution into super in your 30s will really boost your retirement savings and possibly be more tax effective, you should be aware that the funds are locked in for 30–35 years. However, if you’re 55 and planning to retire at 60, you will have access to those funds within five years.
- Size of your mortgage and super balance: Many people have the goal of being debt free going into retirement. So, if your mortgage is still on the high side close to your retirement, you may want to make extra repayments to pay it off. Also, consideration should be paid to your overall debt position such as personal loans and credit cards. On the other hand, if you have always focused on making extra mortgage repayments and you are on track to it pay before retirement, then you may use your extra savings to boost your super balance.
- Comparing your super fund returns vs your interest rate: Your mortgage interest rate is the effective rate of return when you put extra money into your mortgage. In a low interest rate environment, you may earn a better return elsewhere. So you need to ask, how much would you save by making extra mortgage repayments compared to how much you would potentially earn if you invested in super?
Let us consider the current environment of rising interest rates and low super fund returns. Interest rates are rising due to inflation and the Reserve Bank’s policy response. Super fund returns are low due to financial market volatility. Taking the example of the Commonwealth Bank’s standard variable rate on a principal and interest mortgage, which is currently 5.30% per year. Let us assume you can save $20,000 in one year.
- Option 1: Put the $20,000 in your mortgage offset account. This way you are technically reducing your interest payment by $1,060 ($20,000 x 5.30%) in that year and not paying any tax on it because it is a saving, not income.
- Option 2 (a): Contribute the $20,000 to super. If your super fund has an annual return lower than 5.30%, you would have been better off putting the money in your offset account.
- Option 2(b): Even if the super fund earns 5.30%, the return of $1,060 on your $20,000 will be taxed at 15% within super, reducing your net return to $901.
- Option 2 (c): However, if the super fund earns a higher return of say 8% ($1,600) then even after 15% tax your net savings will be $1,360. In this case, it would be worthwhile contributing to super rather than making extra mortgage repayments.
There are a few issues though. The future performance of a super fund is uncertain and past performance can’t be relied upon. Also, as the financial markets are volatile, your super fund’s returns may vary each year but if you have a long-term strategy then you may still be ahead over time. Interest rates can change too, so if we go back to a low interest rate environment making extra repayments to save a small amount of interest may not be the best idea.
It’s important to note that superannuation is a concessionally taxed environment and a long-term investment vehicle. This combination of time, low tax and compound interest makes it a compelling proposition for retirement savings.
For all the reasons outlined above, it’s very difficult to gauge how super returns and interest rates will affect the outcome of your decision in the long run.
Scenario 1: Do nothing
- Mortgage will be repaid in five years with monthly repayments of $1,864.
- Phil’s projected super balance at age 60 will be $512,872.
- Edna’s projected super balance at age 60 will be $343,235.
Scenario 2: $1,000 extra mortgage repayments
- Mortgage will be repaid in three years and two months with monthly repayments of $2,864.
- Assuming they make salary-sacrifice super contributions after the mortgage is repaid until age 60:
- Phil’s projected super balance at age 60 will be $530,426.
- Edna’s projected super balance at age 60 will be $357,352.
Scenario 3: $1,000 extra salary sacrifice super contributions
- Mortgage will be repaid in five years with monthly repayments of $1,864:
- Phil’s projected super balance at age 60 will be $577,683.
- Edna’s projected super balance at age 60 will be $408,046.
From Scenario 3, we can see that if Phil and Edna stick to their plan of being debt free by age 60 and make extra super contributions, their overall super balance will be higher than Scenario 1 and 2.
Scenario 1: Do nothing
- Mortgage will be repaid in 20 years with monthly repayments of $1,898
- Colin’s projected super balance at age 60 will be $642,490
Scenario 2: $1,000 extra mortgage repayments
- Mortgage will be repaid in 11 years with monthly repayments of $2,898
- Assuming he makes salary-sacrifice super contributions after the mortgage is repaid until age 60:
- Colin’s projected super balance at age 60 will be $662,262.
Scenario 3: $1,000 extra salary-sacrifice super contributions
- Mortgage will be repaid in 20 years with monthly repayments of $1,898
- Phil’s projected super balance at age 60 will be $910,017.
Scenario 4: $500 extra mortgage repayments and $500 salary-sacrifice super contributions
- Mortgage will be repaid in 14 years and two months with monthly repayments of $2,398.
- Phil’s projected super balance at age 60 will be $776,253.
If Colin’s focus is purely to repay his mortgage as soon as possible, Scenario 2 is ideal for him and Scenario 3 is ideal if he only wants to focus on building his super. However, with Scenario 4, Colin is able to repay his mortgage much earlier than age 60 and still build his super balance.
So, what should I do?
As individual circumstances are different, unfortunately there isn’t one strategy that will provide the best outcome for everyone. Circumstances change as you age, raise a family, travel or perhaps receive an inheritance. You should regularly review your strategy and possibly engage with professionals such as financial advisers, mortgage brokers and accountants to help guide you through this decision.
Things to consider
- The use of Moneysmart’s Mortgage and Superannuation calculators involves various assumptions as listed on their website (such as an increase in employment income by CPI of 2.50% per year, and super investment returns of 7.50% per year) Therefore, the above figures will be different for every individual. Learn more about SuperGuide’s super and retirement calculators.
- The above scenarios do not assume changes in income, financial markets volatility, interest rates, or ability to save.
- There are other ways to build super balances such as making after tax contributions and downsizer contributions. Learn more about strategies to boost your super.
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