Surely a commonly faced question by anyone who owns a home and has some spare capacity to save or invest after living expenses are met including the basic mortgage repayments is, “should I devote the available cash flow to reducing my mortgage, or invest it instead in tax-deductible super contributions?”
Yet, although it seems like such a basic question, I haven’t seen a very good or very general attempt to answer it.
This is my take on this fundamental question in financial planning.
If you pay down your mortgage, you get a return on your dollars that is equal to the interest rate you pay on your mortgage. Easy. Let’s say you are paying an interest rate of 5% per annum on your home mortgage. (And if you are paying much more than that, but have a good credit rating, you should read Strategy 28 of my forthcoming book, Slow and Steady – 100 wealth building strategies for all ages.) The only thing that may happen to this return in future is that it may vary when interest rates change; for example, currently it is considered possible that there will be two or three increases of 0.25% in the cash rate by the end of 2018, which would typically flow through to mortgage interest rate rises of similar proportions. So far, so good. If you pay $1,000 of your after-tax salary into your mortgage, effectively you get a rate of return of 5% on that money.
But what rate of return do you get on your superannuation contributions? That isn’t quite so straightforward. For a start, the effective return that you will get will be impacted by taxation considerations. If you are prepared to forego $1,000 of your after tax income, because of the tax deductibility of superannuation contributions, you can afford to make more than $1,000 of superannuation contributions, in fact you can afford to make contributions of $1,000/(1-MTR) where MTR is your marginal tax rate including the Medicare levy. By way of example, if you earn more than $180,000 of taxable income, in 2017/18 your marginal tax rate will be 45% plus 2% Medicare levy makes 47%, so if you salary sacrifice $1,000/(1-0.47) or $1,887 into superannuation, you will be in the same after-tax position as if you had paid $1,000 from your after tax income into your mortgage.
Next, you have to allow for the taxation treatment of your superannuation contribution. Generally that will be taxed at 15% on its way into your superannuation fund.
Then, you have to estimate what rates of return will be earned by your superannuation fund in future. This depends on your chosen investment option. If you invest in cash your returns are likely to be low. If you invest in a default fund, your fund is likely to invest in a “balanced” asset allocation meaning that 60% to 70% will be invested in growth assets (shares and property) that fluctuate in value from time to time, sometimes significantly. In this situation your long run return is likely to be higher, but this is not assured and the balance of your account will be much more volatile in the short run than if you had invested in cash.
Finally, you have to allow for tax on your superannuation fund’s earnings and for investment-related fees.
So getting an accurate idea of the return from devoting additional contributions to your super fund isn’t easy. But if you do want to try it, the ASIC MoneySmart Superannuation Calculator will give you some assistance but a word of warning: although it is an excellent tool, it isn’t really geared up to calculate the effective rate of return on your after-tax money. Alternatively you can try to do projections using the Superannuation Calculator and try to compare the results with the results of applying the same regular savings amount to your mortgage using ASIC’s How can I repay my home loan sooner Calculator. But there are a few significant catches – in particular, the Superannuation Calculator produces forecasts in current dollar values, which makes the output difficult from the two calculators difficult to compare unless you take special steps to adjust the output from the Superannuation Calculator.
For my own calculations (reported below) I have adopted the following ASIC MoneySmart assumptions.
- Fund fee level: medium (0.6% per annum indirect cost ratio).
- For the CASH investment option: gross investment return 2.6%, tax on earnings 15%, investment fees 0.05%.
- For the CONSERVATIVE investment option: gross investment return 3.8%, tax on earnings 11.9%, investment fees 0.3%.
- For the BALANCED investment option: gross investment return 4.8%, tax on earnings 7%, investment fees 0.5%.
Using those assumptions it is possible to calculate, for any duration, whether or not the effective rate of return achieved on your after tax money exceeds the home mortgage rate (assumed to be 5%) or not.
Here are my results for the CASH investment option.
Cells coloured in green mean that the expected annualised rate of return on your superannuation contributions (based on ASIC’s assumptions) is more than 5%. Cells coloured in red mean that the expected annualised rate of return on your superannuation contributions is less than 5%. (So green means contribute to super, red means pay off your mortgage).
Here are the corresponding results for the CONSERVATIVE investment option (this means about 30% of your account balance will be invested in growth assets).
You will notice that the green shaded area is larger because the returns expected from your super fund (on ASIC’s assumptions) are assumed to be higher than the returns if your choose to invest your super account balance in cash.
Finally here are the results if you invest in a BALANCED fund (again the basis of ASIC’s assumed rates of return, and ASIC’s assumed superannuation parameters):
There is a lot of green here! The better rates of return mean that anyone earning more than $37,000 with up to 25 years to retirement is better off, and even those with 30 or 35 years to retirement may be better off making super contributions if they are on high taxable incomes.
But in the discussion so far we haven’t talked very much about risk. There is very little risk inherent in accumulating wealth by paying down your mortgage (though there is some risk of future fluctuations in the mortgage rate). By comparison, investing via your superannuation fund in riskier asset allocations means higher expected returns, but also higher risk of fluctuations. The variability of account values tends to flatten out over medium or longer durations but it’s still there.
So maybe what we end up with is a sort of “traffic light” approach, where the picture is as follows:
Here the interpretation is as follows. Green in this last chart means it would seem desirable to make tax deductible super contributions. Even if you put your contributions in cash, you will make a better return than by paying off your mortgage due to the tax advantages of investing in super.
Red means whoa! You may be better off paying off your mortgage. Even if you achieve ASIC’s assumed “balanced” returns, you would be better off paying down your mortgage – even without taking into account that paying down your mortgage is also the safer option.
Orange means “proceed to make tax deductible super contributions if you like, but there is more investment risk here”. By taking an element of risk with your asset allocation (and investing in say, your fund’s balanced asset allocation), you should achieve better than a 5% return if all goes to plan. But this outcome is not guaranteed.
Before making any decision, you should consider your responses to the questionnaire in ASIC’s Super vs Mortgage Tool. For example, if you have credit card debt or a personal loan, it would usually be better to pay off those more expensive debts before making home loan repayments. If you don’t have an emergency fund, you should consider building one before contributing to superannuation. And of course, if you will need access to your super before your preservation age (60 for anyone born after 30 June 1964) then super contributions are not an option.
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