In the world of personal finance, an often asked question is whether you should you prioritise investing or pay off your home loan first?
On paper, the answer is simple.
If you can obtain a better after-tax return on your investments than you can by saving interest, then it makes sense to invest instead of paying off your home loan.
Investment return: 10%
Tax payable: 47%
After-tax return: 5.3%
Home loan interest: 3%
But the reality is much more complex.
Assets don’t go up in value in a straight line like they do in financial models.
They are up, down, and all over the place. Sometimes they do nothing at all for ten years. Sometimes they go up in value for 10 years in a row and then crash 30% when you’ve got your peak savings invested.
Whether you should invest or pay off your home loan faster is a challenging question because we are dealing with the unknown of what your investment returns will be. We won't know the answer until we can look back with the benefit of hindsight.
We can look to the past, but past performance is not a guarantee of future financial performance.
One thing we do know is this…debt reduction is guaranteed wealth creation.
When you reduce debt, not only do you grow your net wealth, you save yourself interest expense in the future.
You also protect yourself from the risk of the decline in value of your investments.
Thoughts on current interest rates:
While interest rates are at historically low levels, I believe the case for investing increases.
After all, it’s easy to beat home loan interest rates starting with a 2 in front of them. But if interest rates were instead 8%, a high income earner paying tax at 47% would need to generate a before tax return of 15% just to match their home loan rate.
And that’s an investment return I would not be comfortable trying to generate.
As interest rates increase, the case for debt reduction increases. After all, debt reduction is a guaranteed return, future investment returns are not.
Another argument against accelerated debt reduction is that over time, your loan becomes easier to afford due to inflation.
As we know, inflation is the general increase in the price of goods and services over time. In order to continue to afford these goods and services, wages tend to gradually increase over time as well. This is why buying a $15,000 house was so difficult 45 years ago, but would be a piece of cake today.
Debt however doesn’t increase (assuming you are at least paying interest).
As a result, the value of a dollar today is gradually eroded over time, making loans much easier to afford in the future.
What I do:
There’s a picture of me on the day I bought my first home.
It’s a picture of melancholy. I knew on that day I was a slave to my debt.
I remember my sister saying “you’re meant to smile when you buy your first home”.
I knew that, in order to meet the repayments, I’d be chained to a job.
Modern day slavery.
For me, I don’t like debt. The positive of this dislike for debt has seen me more motivated than ever to pay it off fast. However, even I can see there is a point of diminishing returns on debt reduction.
As an example, if you’ve got a home loan of $100,000 and interest is charged at 3%, that’s only $3,000 in interest expense per year. However, that $100,000 could instead be invested for the rest of my life, compounding while I sleep.
Last year, I hit a savings goal, the point at which I agreed it was time to start investing. I had a predetermined savings amount, and after that, I felt comfortable with taking more risk to invest. For me, I had passed the sleep at night test, and it was time to start investing more seriously.
It was a great experience and I have resolved to allocate a fixed proportion of my savings to investing, while the remaining savings goes into accelerated debt reduction.
For me, that’s the best of both worlds.
The case for investing and accelerating home loan repayments?
Noel Whittaker, in his book 25 years of Whitt & Wisdom provides a more sophisticated method of calculating what your home loan repayments should be.
His formula is this - repay $12 a month for every $1,000 owning on your mortgage.
So if you have $200,000 owed, that’s 200 thousands, multiplied by $12.
In this case, your repayments would be $2,400 per month.
Noel believes in investing while accelerating home loan repayments. He encourages you to use the $12 for every $1,000 to determine your home loan repayments. All other savings are to be invested.
Another common strategy is to pay off at least of half of your home loan, and then start investing.
While on paper the answer is clear, for me, the answer really comes down to your risk tolerance.
Are you prepared to take on the risk of generating better returns, knowing that capital is at risk? Or are you happy to generate a return without any risk?
For me, debt reduction is important because life happens:
People lose jobs
Unexpected bills pop up
People get sick and can’t work
If you pay down debt and then decide you want to utilise the money for other purposes, you can likely redraw on your loan.
If you stuff up your investing, you can’t call up the company and ask for a refund of your losses.
For me, debt reduction means peace of mind. And for me, that’s worth more than a few extra percent in returns that may or may not eventuate.
Even if you want to focus on investing, I would encourage you to at least use the strategies set out in my guide to paying off your home loan faster for tips. Even if you just use these, you’ll fast track your debt reduction and knock years off your loan. No one ever regretted paying off their home loan faster.
Also, remember that when we are talking about paying off your home loan faster, I really mean putting extra savings into an offset account to offset your home loan. For a refresher on why this is one of the best financial things you can ever do - read this article.
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