Paying off a home loan was often said to be the wisest way to go in financial affairs whenever any extra cash came into a household. Far better to pay down the home loan than try to find a better return elsewhere, in shares or investment property. Now, it is not so clear, as new tax concessions make super more attractive.
Choosing the home loan as a place to put spare cash was always the winner when judged simply on the arithmetic.
Paying off a home loan costing, say, 7.75 per cent in interest was the same as earning a guaranteed return of 13.2 per cent elsewhere before tax, for those on the highest tax rate of 41.5 per cent. You had to earn 13.2 per cent to be left with 7.75 per cent after tax.
Even those on the lower tax rate of 31.5 are effectively earning a return of 11.3 per cent on funds used to pay off a home loan.
Such an analysis overlooks a few fine points. Buying shares can bring franking credits that lower your total tax bill, and can deliver a capital gain when sold, albeit watered down by capital gains tax.
Holding the shares for at least 12 months will cut capital gains tax by as much as half the top marginal tax rate, to a rate of 24.5 per cent.
Buying a family home might also deliver a tax-free capital gain - as a "primary place of residence" is free of capital gains tax on sale. If it's an investment property, some capital gains tax will apply.
In the wake of the Government's changes to super, it's a much closer call to make between super or the home loan, with super probably gaining the edge if you want to live adventurously.
Say 50-year-old Ross has an extra $200 a month in his pocket after the rejigging of the tax scales earlier this year. Should he whack it into the home loan or go for something entirely different?
The short answer is that if he and his family like a quiet, contented life, and a guaranteed rate of return, he should go the home loan route; if he wants more adventure, then a field of options opens up before him. There are at least six options, according to MLC's technical manager Andrew Lawless. First, he could put the extra $200 into the mortgage, or instead into a unit trust or managed fund.
Then there is the super option, soon to be free of exit taxes from next July for those over 60. The extra $200 a month going in would be an after-tax sum known as an undeducted contribution.
A smarter move to improve his long-term wealth would be to lift his super contributions to a higher plane altogether by arranging with his boss to salary sacrifice.
By doing this, Ross could put as much as $342 a month in pre-tax salary into super, and still enjoy the same after-tax income. Ross could even lift up his risk and reward a notch, by borrowing $200 to make a total investment of $400 a month into a unit trust, with gearing at a 50 per cent level.
Going up another notch of borrowing, he could gear to a 67 per cent level and invest $600 a month. Playing into the decision mix is the knowledge that from next July tax on super will effectively fall to 15 per cent - a good deal less than his current marginal rate of 41.5 per cent.
Let's assume Ross pays a top rate of 41.5 per cent income tax. His home loan of $250,000 is costing him 7.75 per cent a year in interest and consuming $3000 a month in repayments.
As shown in table 1, after 10 years the best option for Ross would be super with a salary sacrifice kicker. He would have $54,338 to his name, almost $20,000 more than if he had paid off the home loan early in nine years instead of 10 and put the savings into a unit trust. Better, too, than keeping on with the home loan and investing the spare $200 in a unit trust or as an undeducted super contribution, (options 2 and 3) and better than gearing into a unit trust (options 5 and 6).
As MLC's Andrew Lawless says, the appeal of investing in an existing home loan debt falls away when compared with better-returning investments elsewhere, especially super with end benefits due to be tax-free at age 60 from next July.
Yet another strategy exists for the bold. What if Ross converted the home loan to an interest-only loan? He would have $1585 a month ($1385 a month extra) to work as an investment, by losing the obligation to repay the principal component of his home loan.
As table 2 shows, Ross is much further ahead financially - by $180,803 even after repaying the original $250,000 home loan debt. As Lawless says: "The numbers show that superannuation will clearly be the better investment, in a comparison with a home loan."
The argument for super is helped greatly by the changes that from next July will allow withdrawals tax-free for those aged 60, though it may be an irritant to have to work until that age, says financial planner Peter Hogan of Avenue Capital Management.
"Provided you are prepared to keep working until 60, rather than simply to a preservation age likely to be a few years earlier, the opportunity to take out the money tax-free and pay off the mortgage in one lump is quite attractive. In a sense, you could have money in super accruing in a 15 per cent tax environment, where the super fund return could be well in excess of your mortgage repayment costs - it's an appealing option if you think over the long term."
Making a choice between the options hangs on a couple of critical elements, particularly the twin unknowns of interest rates and investment earnings that have been flying high in recent years.
"The whole strategy is very sensitive to interest rates and earning rates, and to marginal income tax rates," Hogan says. "If you are confident that home loan rates will rise higher and investment earning rates cannot be sustained at the levels of the past three years, then you are better off paying down the home loan."
And there are a few other thoughts to consider before making a commitment, according to Colonial First State senior adviser Julie Fox.
"You might not be comfortable in not paying down a mortgage ahead of retirement, and not sure that the Government will stay true to its word on the rules on super," she says.
"We've yet to see all the fine print on the super taxes after next July. It's unlikely that the Government will change its mind, but one has to wait and see."
For younger people, there is the nature of super, which is money locked away until retirement age. Some may prefer to have their wealth readily accessible in a unit trust, to be withdrawn whenever needed, such as in an emergency. Most home loans have redraw facilities that also can be a source of emergency money.
So what's the verdict?
Says Lawless: "You'd be better off paying off the home loan, if you are risk averse and prefer a guaranteed rate of return, or you are not prepared to lock up your money in super.
"But if you are prepared to invest in growth assets, such as shares or a unit trust, you can do a lot better than paying off your home loan."
According to Hogan, if someone is willing to be moderately aggressive in their super investing - say 75 per cent in growth assets of shares and property - then going the super route may well be more attractive.
"If you take a view that home loan rates don't have a long way to move, then pumping your money into super and later paying off your mortgage at 60 could be an option."
Julie Fox says a strategy of investing in super ahead of a home loan will appeal to people who already have substantial equity in their home, and who happen to be close to 60 (when super funds can be withdrawn tax-free).
"A shorter time frame in the strategy would minimise the legislative (government) risk," she says.
Source: The Australian, Tim Blue
