Best of 2023 #3: What should be your priority: repaying your home loan or invest?

Are skyrocketing interest rates making you question your investment strategy? I'm Stuart Wemyss, and on the Investopoly podcast, we tackle the dilemma facing many investors today: whether to pump surplus cash into investments or chip away at that home mortgage. As we bid farewell to the comfort of low interest rates and brace for the impact of significant hikes, this episode guides you through the emotional and financial intricacies of debt management versus investment growth.

Bearing witness to history's lowest interest rates, many of us are now reeling from the sharp climb, questioning our next financial move. Join me as we dissect the implications of a 5.8% home loan interest rate on your cash flow and compare the long-term benefits of extra loan repayments against the potential returns from growth investments. We'll navigate the complexities of after-tax returns and savings, helping you make an informed choice to secure your financial future amidst the current economic landscape.

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This podcast provides general information about finance, tax and credit. It doesn't take into account your specific objectives, financial situation or needs, so you need to assess whether it's relevant to your circumstances before acting on it. If you're not sure, speak to a licensed, trustworthy professional.

Transcript

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Speaker 1 0:00

Hi , this is Stuart Weems and welcome to the Investopoly podcast . My goals to give you simple , easy to understand strategies , insights and tips to help you master the game of building wealth , and what I want to do is share with you the top three podcast episodes recorded for 2023 . And this is the third most popular podcast I did this year . In this episode , I considered whether you should continue to invest or , because interest rates have risen so much so quickly , whether you're actually better off to direct your cash flow towards repaying your home loan . And I think this is interesting because it's natural to think well , interest rates have risen so high , particularly if you've got non-tax deductible debts or home loan . You've got to pay though that the interest from after tax dollars , you know , because you don't get a deduction for your home loan , and that can be quite expensive , particularly if we're coming off a period of very low interest rates . You know we all got used to sort of interest rates in 2 to 3% and we got seduced by the central bank to believe that maybe rates weren't rising any time soon . It was a bit of a shock when interest rates did rise so significantly and , interestingly enough , I've referred back to this podcast episode through a number of client conversations , and clients have referred back to it as well , and I think the point here , or why it's so valuable , is because the emotional reaction is to reduce debt , you know , to direct more cash flow towards debt reduction , but the evidence-based long-term investment approach really is to continue with the investment strategy and continue with regular investing . Anyway , let's jump into the episode and I hope you enjoy it .

Speaker 1 2:00

What I'd like to talk about in this episode is is it worthwhile continuing to invest when home loan interest rates have risen so much ? Of course , over the last couple of years , particularly when home loan interest rates fell to almost 2% , there was a lot of even fixed rates below 2% it was kind of a bit of a no-brainer to put all your surplus cash flow , or more surplus cash flow , towards investing in growth assets , because the chances are you're going to earn a lot more than 2% over the long run . However , of course , interest rates have risen by around 4% over the last 14 months , and so it's good to revisit that decision of how should you allocate your surplus cash flow , particularly if you have a non-deductible home loan debt . You know a lot of my clients invest money in the share market every month on a regular basis , as well as direct some of their surplus cash flow towards debt reduction , and should they continue doing that and in what proportions ? So the first thing to realise is that extra repayments on home loans compound the return , actually compounds . So , for example , if I repay $10,000 off my home loan and my interest rate is 6% , I'll save $600 in interest over the next 12 months . If I continue to pay another $10,000 extra next year , then my total saving increases to $1,200 . It's really the 600 that I save on the 10,000 extra repayments last year and then the $600 that I save on the $10,000 of extra repayments this year . So $20,000 in total . And of course , those savings compound over time , which is the real powerful benefit of making repayments as soon as you can .

Speaker 1 3:45

But it's also true that investment returns compound also , and that's really the most successful way to build wealth over time is really to enjoy those compounding annual returns . Over a couple of years they're not that significant , but after 20 years of investing they really are quite significant . And to benefit from compounding returns . Obviously you probably want more of your return in capital growth and income , because it leaves more to compound each year . Of course , if you get income and pay tax , then you can reinvest the net amount after tax , but it's a lesser amount , whereas obviously with capital growth , we don't pay tax on that every year until we sell the asset , and so having more capital return and lower income return really helps that compounding impact .

Speaker 1 4:31

So since both situations compound that is , repaying a loan , a home loan , or investing in growth assets then really what we need to do is compare the after tax return or after tax saving for each scenario , and the one that's going to deliver the highest after tax saving slash return is the one that's beneficial . So if we have a look at home loan interest rates today , they're around about 5.8% . That's for a home loan , so not an investment loan on principal interest repayments . So if you're going to make additional repayments , that's your saving or return is about 5.8% . Now what about investment returns ? Well , of course , future returns are a little bit less certain than future interest rates , of course .

Speaker 1 5:17

But if you have a look at the Australian share market , it's returned 8.5% over the last 10 years , compounding annual growth rate , and about 9% over the last 20 years , and if you have a look over the last 40 years it's north of 10% . So let's assume 8.75 , which is kind of the midpoint between the last 10 and 20 years . So if your total return is 8.75% , you can probably assume you'll get a dividend yield of about 4.5% and the remaining amount , which is 4.25% or 4.25% , will be capital growth . Now it's going to depend on what your marginal tax rate is , what your after tax return will be . But your after tax return is going to be somewhere between 7 and 7.8% on an after tax basis . Now it depends on whether you're on the highest marginal tax rate or the second . Highest has a big impact because you've got imputation credits associated with the dividends . So really , based on that comparison , you're somewhere between 1.2% to 2% better off to continuing to invest in growth assets as opposed to repaying your home loan . And of course that's looking at returns over the past 10 and 20 years . As I said , longer term returns in the Australian market are actually better than that . So probably best to probably say over very long periods of time you're somewhere north of 2% better off to invest in growth assets as opposed to repay your home loan .

Speaker 1 6:52

Now there's one really important point that I must make . Home loan interest is guaranteed . Returns are not Investment . Returns are never linear . They're never straight line . There's always going to be some volatility . However , interest rates are very much straight line in that you expect to pay interest this year , a certain amount of interest , and the amount of interest that you need to pay over the next 12 months is relatively easy to ascertain . You know within a range what interest rates are going to be , whereas with investment returns they're very volatile . You don't know what they're going to be . Therefore , there's no guarantee that if you invest in the share market , as opposed to putting that cash flow towards repaying your home loan , that you'll be better off in 12 months time .

Speaker 1 7:37

Short term returns are impossible to predict and , as I said in this podcast many times , you know I caution people from trying to make short term returns . You'll end up making mistakes , strategic mistakes . Instead , focus on what is going to be best for you over long run rather than focusing on the short run Now . Looking at returns is only really part of the picture . You really do need to consider your overall circumstances , your strategy , your risk tolerance , any potential changes in the future and so forth to really work out what you should be doing with your cash flow . So you know , looking at returns really is fine , but excludes any consideration of your own personal circumstances .

Speaker 1 8:21

For example , if your cash flow is very sensitive to interest rates , so you have a high amount of debt compared to your income , then probably the safest option for you is to direct most , or if not all , of your surplus cash flow towards debt reduction , to reduce the sensitivity that you've got towards debt . If you expect future changes with respect to your income , such as starting a family or something like that , you might decide that it's better off actually to build a cash flow buffer or a cash savings buffer in your offset account as opposed to investing in growth assets . And if you're young and you have little assets , little investments to your name , then you would prioritise investing over debt reduction and in that situation , you're better off to probably investing growth assets than make additional loan repayments . My point is that you need to consider both . You need to consider what's fundamentally the right approach and then also what is the right approach in your circumstances , given your goals and situation and so forth . Now one thing to think about is , instead of it being either or decision so where should I put my cash flow ? Maybe you can do both .

Speaker 1 9:34

So for some people , and depending on their situation , borrowing capacity and all that risk profile and all those sorts of things . For some people , they might be actually better off directing their surplus cash flow towards debt reduction , as in reducing their non-tax deductible home loan and then borrowing to invest in the share market . For example , instead of investing $5,000 a month in the share market , maybe you're actually better off to put that into your home loan and go and borrow $5,000 and use that to fund the share market investing . In that situation , there's no net change of debt because you've repaid $5,000 and you've taken out an additional $5,000 worth of borrowings . The difference is that what you're doing is that you're reducing your non-tax deductible debt in return for increasing your tax deductible debt , which obviously is more tax effective , particularly when interest rates higher today than they were a couple of years ago , and this really gives you the best of both worlds .

Speaker 1 10:32

Now you shouldn't misuse this strategy . You know you shouldn't use this strategy because you can't afford to invest in the share market or the only way you can afford to invest in the share market is borrowing . That would feel too aggressive to me . Instead , this strategy should be used as a cash flow management strategy . That is , I have the money to invest if I wanted to , but I just want to direct that towards non-tax deductible debt reduction instead of un-geared investing .

Speaker 1 10:58

Now , one of the most important points I'd like to leave you with is that consistency is far more important than intensity . You don't want to chop and change with an investment strategy . Sticking to an investment strategy irrespective of what's happening with markets , interest rates and those sorts of things , not being blind to changes in your circumstances or goals , of course , but really sticking to the strategy is really important . So I would really caution people if they've had a really good strategy and they've decided that regular share investing , for example , is part of that strategy . Don't get distracted just because interest rates have risen . Now you might want to revisit and change the amounts a little bit and tinker with it at the edges , but overall , you don't really want to change your strategy . We know that investing in the share market , for example , on a monthly basis for the next 10 to 20 years will help you build a substantial amount of wealth . It won't build a lot of wealth in the next five years , but if you do it for 10 , 15 , 20 years , you know very long periods of time . We know the compounding capital growth , and I've written about that previously . So stick to the strategy , don't get distracted just by short term interest rates .

Speaker 1 12:10

Now , before I leave you , I just need to highlight one correction . Last week's episode , I discussed the six year capital gains tax main residence rule . So that's really a rule that allows you to continue to claim a main residence whilst you've moved out , as long as you don't claim another main residence . I said that you need to reoccupy or sell that property before that six year period is up . Unfortunately , I was incorrect . You don't have to do that . If you don't reoccupy the property or sell it before that six year rule has , or six year period has , elapsed , it's fine . You continue to enjoy that six year period of no capital gains tax and your capital gains tax starts from six years and one day onwards . So apologies for that oversight or error . Of course corrected the blog on the website and thank you very much to Todd for highlighting that . Okay , until next week . Bye for now .