With interest rates on the rise and the Reserve Bank set to continue raising the cash rate into 2023 to curb inflation, making additional payments towards a mortgage to avoid the additional interest owed is a consideration on the minds of many Australians. The following article will outline the advantages and disadvantages of each approach and the factors that both investors and borrowers may need to consider.
Focusing on your mortgage
Many borrowers are feeling the pinch of increasing interest rates which banks are passing on to their customers and increasing the cost of their debt. Mortgage rates are expected to climb above 5.5% and therefore it is important for borrowers to understand the different benefits, costs, and risks of whether they choose to pay down their debt at a faster rate or allocate this cash elsewhere.
Based on an interest rate of 5.5%, a household with a 30-year, $750,000 mortgage can now expect to pay $783,000 in interest over the life of the home loan. However, if these borrowers paid an additional $100 per month, their mortgage would be paid off 18 months earlier and they would be required to pay $51,000 less in interest over 30 years.
If these payments were increased by $200 per month, this added boost would decrease the term of the loan to approximately 27 years and cut the interest paid by $96,000. Therefore, highlighting the potential savings which are on offer for those buyers who are able to make extra repayments. Prepayment may also provide you with different personal benefits including peace of mind that you are working towards becoming debt free which may set you up with a more comfortable retirement. Whatever strategy a borrower chooses should be based on what they are comfortable with as well as what best aligns with their short, medium, and long-term goals.
Borrowers should also consider the disadvantages of allocating additional funds towards paying off a mortgage which is the opportunity cost. This refers to the potential benefits that an individual may miss out on when choosing one alternative over another. This could include using this cash to invest or boost your super, each of which has its own tax implications, benefits, and risks.
With inflation and interest rates on the rise, consumer sentiment is more negatively skewed as Australians reduce their spending and sell their investments. Despite this, current economic conditions could provide investors with opportunities to invest in shares and other investments which are effectively ‘on sale’ due to market volatility. To learn more about what to invest in during a bull and bear market, click here.
According to Money Smart’s compound interest calculator, if you started with a $75,000 investment today and contributed $200 per month at a rate of 7.5% p.a., your investment would be worth approximately $904,780 at the same time your mortgage would be paid off (30 years). Investing across a range of high-quality asset classes also provides you with the benefits of diversification which can both help to build your wealth whilst also protecting you against volatility and potential declines in the property market.
Investing in your super is also a consideration that borrowers need to take into account before making plans to prepay their mortgage. Investing in super is for the long term and individuals should be aware of the different rules and limitations of accessing their super before retirement age. However, super comes with many tax benefits as earnings are generally taxed at a rate of 15% and all earnings and income generated is tax free during the pension phase. Most income earners would be taxed at a marginal rate higher than this, and therefore receiving a significant tax concession in addition the compounding effect of time has the potential to produce significant returns for investors.
There are strict rules around this which include the concessional contribution cap of $27,500 p.a. However, if you have a balance of less than $500,000, these unused caps can be carried forward from 2019-2020 on a rolling five-year basis. The more money that individuals allocate to their super, the more money they will have in retirement. If you started with a $10,000 deposit today and made monthly contributions of $500 with an average return of 8% p.a., your super balance would be approximately $780,000 in 30 years.
Ultimately, it is up to individual borrowers and investors to consider which approach is the most viable strategy for them and their financial goals and objectives. If you would like tailored guidance and advice on which strategy is the best for you, based on your individual circumstances, please click here to organise a complimentary 20-minute phone call with an EPG Wealth adviser.