The case for repaying your home loan

Making extra repayments to your home loan provides you with a boost to your long-term wealth by reducing the amount of loan interest paid over the term of the loan.  The interest savings are your effective rate of return.

The case for investing

Investing for the long term provides you with a wealth boost due to the long-term compounding of investment returns.

What should you do?

Unfortunately, there is no one golden rule. The answer depends on many factors and needs to be tailored to each person’s unique financial situation and longer-term objectives.

4 things to consider:

1.    The effective rate of return achieved by repaying your home loan

The current average home loan rate is around 4% per annum (some are lower, some higher). However, you cannot claim a tax deduction for the interest on your home loan and you must pay tax on your salary before you devote some of your earnings towards the loan repayments.

To compare your investment return to your home loan interest rate you need to consider tax. The table below provides a summary of the required rate of return needed from your investments to beat the effective return of repaying your home loan early.

Please note: The above effective rates for investment returns do not consider capital gains tax – this tax is payable on 50% of the profit from investments held for more than 12 months and can further increase the return required to break even with repaying your home loan early.

2.    Your home loan interest savings are guaranteed

While it might look attractive to not make extra repayments while interest rates are low (6.6% in the above table looks achievable), you need to be mindful of the risks taken to get your returns.

Making extra repayments on your home loan saves you interest and those savings are guaranteed…whereas your investment returns may not be guaranteed.

3.    What about superannuation?

You could also consider making extra contributions to superannuation from your gross salary – also known as salary sacrifice contributions – rather than making extra home loan repayments.

Such a strategy reduces the required investment return due to the lower tax (15%) that applies to superannuation contributions made via salary sacrifice.The downside is that there is a maximum limit on the amount that can be contributed to superannuation in this fashion – $25,000 per annum inclusive of your employer’s superannuation guarantee contributions.

Anyone earning more than $263,000 per annum would already have $25,000 per annum being contributed to super by their employer.

You could make after tax contributions to superannuation (up to $100,000 per annum) however this requires the same rate of return as your marginal tax rate and the money is locked in your fund until you retire (and are over 60).

4.    Building flexibility into your plans

Repaying your home loan early provides you with the ability to refocus future income to wealth creation. It also reduces the impact on your personal cash flow situation should interest rates rise in the future. This is important for those whose loan repayments are already a stretch.

So, what is our advice?

Generally, most people are better off to focus on the repayment of their home loan as a priority.

Then, once the loan has gone, the cash flow that was previously devoted to the loan repayments should be re-directed to saving towards your longer-term wealth and financial freedom.

If you are unsure about your own circumstances, the financial advisers at Hewison Private Wealth can help. Book a Meeting or Send us an Email if you’d like an obligation free discussion.