By Scott Francis
|PORTFOLIO POINT: Whether to pay extra money off the mortgage or into superannuation depends partly on your time to retirement.|
In the old days the rules of the game were simple. You would buy and pay off your house, work until you were 65, live on the age pension for a few years and then move on for good.
Then things got more complex. Our expectations of retirement grew, our life expectancy increased and suddenly we need more than our own home and the age pension. Conventional wisdom has been based on paying off your mortgage as your number one priority. Indeed, there was much wisdom behind this thinking. Paying off your mortgage provided a tax-free, risk-free improvement in your financial situation and, once the mortgage was paid off, your cash flow position also improved allowing you to build investment wealth.
Until recently this was the conventional wisdom ? extra repayments to the mortgage made great sense. But now they made superannuation more attractive than ever, and the balance has changed.
Under the proposed superannuation changes, superannuation will have three layers of tax advantage that will help lever a person's financial situation:
Layer 1: A salary sacrifice contribution to superannuation is taxed at up to 30¢ less in each dollar than normal income.
Layer 2: Earnings in the superannuation environment are taxed at up to 30¢ less in each dollar than if they were in your own name.
Layer 3: After the age of 60 all drawings from superannuation are tax-free and, if taken in the form of a pension from a fund, these earnings of the fund are tax-free as well.
The question this article addresses is: Now that superannuation is more attractive than ever, should the conventional wisdom that paying off the home is your first financial priority be rethought? Don't dismiss the importance of this question. It is going to be at the core of people's financial strategy. Most people's key assets will be their superannuation and their homes, and being effective and business like in dealing with both assets will be the cornerstone of financial success.
This discussion about balancing paying off the mortgage and making additional superannuation contributions is a relatively complex one. It involves both numerical calculations, and non-numerical judgments.
An easy way to compare the two alternatives is to imagine how best to invest $1000 you manage to have free each month.
Paying additional to the mortgage
Let us consider a 35-year-old couple. The have just taken out a home that includes a mortgage of $350,000. They have interest-only repayments on their mortgage of $2280 a month based on an interest rate of 7.82% and $8 a month account-keeping fees. As well as the basic interest repayments, they have a further after tax cash flow of $1000 a month. Their decision: do they contribute this to superannuation or make additional mortgage repayments on their house?
Assuming a constant interest rate of 7.82%, the $1000 a month additional repayments to their mortgage will see them own their own house outright in just over 15 years ? 15 years and three months to be exact.
This will be a good financial position for them to be in. By the time they are aged 50, they will own their own home, have built up some superannuation through the compulsory 9% contributions and have surplus cash flow of $3280 a month (the amount they were paying off their mortgage) to go ahead and increase their financial situation in the 10 or so years to retirement.
What if they salary sacrificed the $1000 to superannuation?
The second part of the scenario looks at what if, rather than contributing the $1000 a month to the mortgage, they used this money as a salary sacrifice to superannuation.
To start with, the $1000 a month equates to $1460 of pre-tax earnings, assuming that their tax rate is 31.5%. (they have to earn $1460 of income, pay $460 of tax at a rate of 31.5% to end up with $1000 a month surplus). The $1460 a month salary sacrifice to superannuation will be taxed at the superannuation contributions tax rate of 15%, meaning that the monthly after-tax contribution to superannuation will be $1241. This is the first advantage of superannuation at work: the superannuation salary sacrifice of $1241 is 24% greater in value than the $1000 after tax contribution to the mortgage.
To compare the two scenarios we have to assume an appropriate investment rate, after fees and taxes, for the superannuation fund. I have assumed:
A 10% return on growth assets (Australian shares, international shares and listed property trusts).
A 6% return on defensive assets (fixed interest investments and cash).
An asset allocation of 75% growth assets.
This is a gross return of 9%. After fees and taxes I have assumed a return of 7.5% per annum. Over the period of 15 years and three months the superannuation accumulation will have grown to $443,000 in value.
Here are the two situations:
Situation 1: Additional mortgage repayments: In this case after 15 years and three months the couple in the example owns their own house outright.
Situation 2: Additional superannuation contributions: In this case the couple in the case study will still owe $350,000 on their mortgage (having made interest-only repayments), however they will have an additional superannuation accumulation of $443,000.
Which is preferable? On a purely numbers basis, the $443,000 in superannuation benefits, knowing that in 10 years (at age 60) this can be withdrawn tax-free to pay off the mortgage, is the more attractive scenario.
Note that the value of the house is not important. In both cases we own the house and will have benefited from its increase in value over the 15 years and three months. The difference between the two scenarios is that in one the couple are mortgage-free, in the other the couple have a $350,000 mortgage and $443,000 in superannuation.
We need to keep in mind that the superannuation changes have reduced the ability to make large salary sacrifice contributions to superannuation close to retirement. The maximum annual tax deductible contributions will be $50,000 a year, about half what has previously been allowed. This increases the onus on people to start making additional superannuation contributions earlier in life, as they will not be able to "ramp up" their contributions close to retirement to the extent that they have previously.
However there is more to this than just money involved in this decision.
The non-financial factors
There are five strictly non-financial factors that I have included. They are:
The personal goal to own a house outright
The "liquidity" of a house
Interest rate risk
Length of time to retirement
Owning a house outright is a key financial and lifestyle goal of many people. If that is what drives a person, and they get a sense of security that comes from owning their home debt-free, then this provides a strong reason to focus on paying off the mortgage as the primary goal.
Many loan products offer redraw or offset account facilities, allowing money to be taken back out of loan accounts. Although there is a huge downside to the misuse of these facilities (that people keep redrawing from their loans and never actually pay off their debt) the upside is that they provide a useful "cash reserve". This can be used to meet important costs such as unexpected medical expenses. This cash reserve effectively makes the equity in a home a "liquid asset" that can be accessed. On the other hand, the additional superannuation contributions will not be available until age 60 (a long way off for a 35-year-old).
Legislative risk is the risk that the rules governing superannuation will change. For example, if a 25% tax was suddenly passed on all superannuation withdrawals, the $443,000 in super in the example would only be worth $332,000 on withdrawal ? not enough to pay off the $350,000 mortgage. While there is a legislative risk, I would suggest that it is mitigated by two factors. The first is that the trend of superannuation reform has been in the favour of superannuation investors for some time; and there is a natural incentive for the Government to keep supporting people to be self-sufficient in retirement. The second is that when changes are made, any benefits accrued tend to be protected, and the changes only affect future contributions.
The past 25 years have seen two significant spikes in interest rates, one in the early 1980s and again in the early 1990s. Additional repayments will help home owners better able to cope with any sharp increases in interest rates. Indeed it makes sense that additional mortgage repayments should be made until there is confidence that a sound position has been built, ensuring the ability to cope with any sharp rate rises. All the superannuation in the world won't help you if five years down the track interest rates are 16%, house prices have fallen sharply, and you cannot meet your interest repayments and are forced into a distressed sale of your home.
For those people closer to retirement and weighing up additional mortgage repayments against additional superannuation contributions, the additional superannuation contributions make more and more sense. The closer you get to being able to access your superannuation tax-free, the more attractive additional superannuation contributions become.
The decision to make additional mortgage repayments or superannuation contributions is a complex one involving numbers and emotions. There is not a one size fits all solution.
That said,I have proposed a solution that looks at this decision in three stages, each with a different strategy.
Stage 1: Early Stage. Build protection against interest rate rises and build an initial equity position. In this stage the focus is on aggressively reducing the mortgage. This puts the home owner in a position that future increases in interest rates can be managed. It also means that the equity in the house becomes available to redraw, providing financial flexibility if there is a crisis.
Five years of additional repayments should see people in a strong position in their mortgage.
Stage 2: Getting ahead on the mortgage with additional superannuation contributions. The example in this article considered additional mortgage repayments or superannuation. In reality it doesn't have to be black and white like this: why not combine some additional mortgage repayments with extra superannuation contributions? In the example we looked at, why not put 40% of the surplus cash flow into superannuation and 60% into the mortgage? This recognises the extra importance of superannuation contributions while still getting ahead with the mortgage.
Five to 10 years of this balanced approach will see the mortgage reduce and superannuation increase.
Stage 3: Closer to retirement, focus on superannuation. For those people with a mortgage who are five to eight years from retirement, there is a lot to be said for making the minimum mortgage repayments with the emphasis on additional salary-sacrifice contributions to superannuation.
Focusing on superannuation close to retirement makes sense, with a tax-free lump sum withdrawal from superannuation being used to pay off the mortgage at retirement.
Will the new rules that make superannuation investments more attractive than ever create a new balance in the way people own property and build their superannuation assets? Probably not; however they will see a subtle shift in the way shrewd individuals will focus more, and earlier, on building their superannuation assets.