One of the more common questions we get is whether or not it is better to concentrate on paying off your mortgage or instead maximise pre-tax super contributions. This is one of the more difficult questions to answer easily as numerous variables impact the outcome. Although the outcome does depend on personal circumstances, we will explore the issue further below.
Understanding the Pre and Post Tax cost of Home loans
Home loans are paid off using after tax dollars. The effective after tax holding cost of a home loan is equivalent to the interest rate charged by your financial institution. It follows that the pre-tax holding cost can be worked out by the following formula:
Pre-tax cost of interest = Interest rate charged / (1 – marginal tax rate)
Interest rate charged by bank: 7.00%p.a.
Marginal tax rate: 46.5%
Output: Pre-tax cost of interest = 13.08%.
When faced with the decision, do you reduce your mortgage or consider investing instead, the above formula proves helpful. In the above example, an investment opportunity would need to return at least 13.08% before tax for you to be better off than by simply reducing your mortgage. Finding an investment that returns more than 13.08% may be possible, but any such investment would not be risk free. The closest thing to a risk free investment would be government bonds, which currently yield no more than 5.30% (before tax). It therefore follows that when an apples versus apples comparison is made, and by that we mean when risk is taken into account, paying off your mortgage provides the optimal solution.
Salary Sacrificing into Super
In the first section of this Newsletter we outlined how salary
sacrificing into superannuation may be of benefit. We will not
repeat the detail except to say that salary sacrificing into
superannuation is generally more tax effective than having your
salary taxed at your marginal rate when your income exceeds
$37,000. The threshold level of $37,000 is important because that
is the level where the individual marginal tax rate scales
increases from 15% to 30% (before Medicare levy). At that rate
$10,000 salary would be subject to $3,000 tax, resulting in an
after tax sum of $7,000. If instead that $10,000 was sacrificed
into superannuation, then the 15% tax levied on pre-tax super
contributions would result in an after tax contribution of $8,500.
In simple terms, the higher your marginal tax rate, the greater the
tax benefits associated with contributing to super on a pre-tax
At this point, it becomes more obvious that investing into superannuation can be more tax effective than to simply payoff your home loan when your marginal tax rate is at least 31.5% as every dollar contributed to super is worth far more after tax than if taken as cash. Yet we also know that a $1 used to reduce your home loan usually provides a greater return than the same $1 (after tax) invested into superannuation alone (on a risk adjusted basis).
Salary Sacrificing into super versus paying off your home loan So, when the power of compounding is taken into account, will you still be better off by making concessional contributions into super over a lengthy period of time (eg. 15 or 25 years). Instead of making additional home loan repayments ? As we shall see, this requires more intensive modelling, and is perhaps best shown by a number of examples as follows:
Joel earns $100,000 per annum plus 9% super. He has a 25 year, $300,000 mortgage. Before mortgage payments, his living expenses total $30,000. Over 15 years, would he be better off salary sacrificing an additional $9,000 per year into super or increasing his mortgage repayments by an amount that equalise his after tax cashflows.
Under these circumstances, Joel would be materially better off by salary sacrificing into superannuation rather than increasing his mortgage repayments. Over 15 years the benefit equates to over $55,000.
Assume the same set of circumstances as above, except that this time interest rates on home loans have gone up significantly to 11.5%. Would Joel still be better off salary sacrificing to superannuation rather than increasing his mortgage repayments?
Comments: Under these circumstances, Joel would be marginally better off by increasing his mortgage repayments rather than increasing his salary sacrifice contributions. It would of course by unusual for interest rates to be this high for so long so this analysis is more for theoretical purposes only.
Assume the same set of circumstances as per example 1, except that this time we have assumed that the returns in superannuation equate to the risk free rate (the Commonwealth Government 10 year bond rate, say 5.00%p.a.). In other words, paying off your mortgage is risk free but so is contributing to superannuation if you invest purely in Government bonds (a true apples versus apples comparison). Under these circumstances, would Joel still be better off salary sacrificing to superannuation rather than increasing his mortgage repayments?
Even on a risk adjusted basis, where we assume the return from superannuation investments equates to the risk free rate (Government bond yield), Joel would be better off by increasing his salary sacrifice contributions rather than increasing his mortgage repayments.
Individuals on a marginal tax rate of 31.5% or higher who have surplus funds available, after making the contractual minimum mortgage repayments, will normally be better off salary sacrificing into superannuation rather than using the surplus funds to increase mortgage repayments. This will normally hold true even when the return on superannuation equates to the risk free rate (Government bond yield) unless mortgage interest rates rise to 9% or higher. If we assume the superannuation investments return at least 8% before tax, then mortgage interest rates would need to exceed 10% before an individual would be worse off by salary sacrificing. As personal circumstances differ, we can assist you with an individual assessment should that be of interest.
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