For many people, it seems like a no-brainer to keep paying down their mortgage.
After all, it is very difficult to produce a guaranteed after-tax return higher than your mortgage interest rate.
There are, however, two very good reasons to keep your mortgage and not pay it out early, even though an early discharge is also a solid strategy for the more conservative investor.
The advantages of paying off the mortgage in full are obvious—it eliminates the risk of default, allows for more wiggle room in the monthly budget and slashes years of repayments, saving many thousands of dollars in interest.
So, what are the downsides?
Banks Won’t Always Keep Lending
Well, one that many forget to consider is that banks will not always remain keen to lend you lots of money.
Banks love looking at “earned income” when considering mortgages and as you get older they become more stingy about lending to someone whose earning capacity is on the wane.
That means that by the time you are half way through paying off your loan, it may be a mistake to discharge it prematurely.
By using an offset account you achieve the same financial result as paying off the mortgage but hang on to the flexibility of being able to get your hands on some serious change should that be needed at any time in the future.
All of those upfront mortgage fees have been paid so why not make use of this extra flexibility and opportunity?
An Ideal Parking Spot
An offset account is also a great place to “park” any unallocated money such as an emergency fund and to maximise the benefits of saving it.
The offset account can also be used all the way up until it is entirely covering your borrowings – effectively you are then debt free and paying no interest but the offset in reserve as a rapid line of credit if needed.
Just remember that you do still have an active mortgage and will still be making mortgage payments each month out of the offset account, you just won’t be paying any interest other than account keeping fees.
Diversifying Your Investments
The second big advantage of not paying down your mortgage early is to diversify into other assets that will produce long term income and capital growth.
This can be done in two main ways – by systematically investing extra into super each month instead of paying off the mortgage or using this cash to invest in the share market or an investment property directly.
The super part of this strategy becomes really attractive the closer your get to retirement age because the money put there will be available to pay down the home loan in full when you stop working at 60 or under any circumstances when you turn 65.
Tax Advantages Aplenty
Super has great tax advantages – if you can afford to have the money locked away until you hit a condition of release, it is likely to outperform paying down the mortgage directly due to the lower tax environment.
By contributing to super instead of the mortgage as a salary sacrifice (pre-tax), or claim it as a personal contribution, you lose only the 15% contributions tax.
That is a big benefit compared to paying personal tax of up to 47% including the Medicare levy before it hits the mortgage account.
Effectively you will be saving 85c of every dollar in super compared to just 53c in the dollar if you are on the top tax rate.
If you are concerned about market fluctuations within super, you could effectively quarantine this extra by upping the cash allocation within your fund.
Then when you retire or have access to your super you can simply use these extra contributions to pay down the loan or put it in the offset account to keep the mortgage available.
Building up extra investments that can be used to finance your lifestyle outside of super is also quite a flexible and worthwhile goal because it enables you to diversify away from just property and into some other asset classes such as shares.
Debt Recycling an Option
Another possibility is using tax deductible investment loans such as a margin loan to broaden this exposure further and effectively turn non-tax deductible home loan debt into tax deductible debt.
This is often called debt recycling.
While paying down the mortgage does offer an attractive guaranteed return, it comes at the expense of an opportunity cost of the missed growth that you could have been earning somewhere else.
It is true that after the mortgage is paid off there will be a greater chance to invest elsewhere with the extra cash available but this will have missed possibly many years of compound growth that is likely to have been forgone and will be difficult or impossible to catch up on.
The key is, of course, to ensure that the returns available in your super or other investments are higher than the interest rate on the mortgage—something that is generally, but not always, the case.
In general terms, Australian shares and property have returned an average of 8 to 9% a year over the past 30 years—comfortably above mortgage interest rates at the moment, but obviously with more volatility in any particular year.
