A common question we get is whether to put surplus funds onto the mortgage to pay it off faster or to add to super where compound interest will help boost the retirement nest egg.
Before I launch into the pro’s and con’s of doing either the first thing to keep in mind is that there is no answer that is the same for everyone. We all approach our finances differently and the impacts of various strategies on our health and wellbeing will be wildly different between even two similar-looking people.
From a technical standpoint, quite often the winning strategy is to contribute to super and then withdraw at retirement and pay out your remaining loan.
With that in mind, maintaining debt with even record-low interest rates is full of traps for the unwary.
Tax benefits of a retirement plan
When you save money to anything, whether it’s paying down your mortgage or investing to superannuation, you need to consider what it’s worth in after tax dollars.
Every dollar that you earn from working has tax taken out of it, I’m sure you’re well aware of this as for most of us it’s the most painful part of our paypacket. Each dollar that you earn is taxed at a marginally higher rate – the more you earn the more tax you pay. For simplicity, I’m going to use the most common tax rate of 30%.
Let’s say, in your bank account, you have a spare $700 per month that you can allocate toward either super or your mortgage.
If you make additional payments to your mortgage then at the end of the year your outstanding balance will be $8,400 lower and you’ve paid less interest as you’ve got a lower amount for the interest to be charged to. As interest rates are so low, if we assume you pay 3% then you could have saved $252 in interest.
If you salary sacrifice this $700 to super things look a little different. Firstly, salary sacrifice means you put the money to super using before-tax money ie before 30% is deducted. This means your gross surplus is actually $1,000 ($700 net plus 30% or $300 tax). Superannuation is not tax free yet so there is 15% tax to pay so there’s actually $850 per month getting added to your super which adds up to $10,200.
Saving the funds to super in this way gives you $1,800 per annum in additional savings and then you get the earnings from super on top of this.
Earnings from super of course becomes a completely separate topic but on average all you have to do is beat the 3% mortgage rates annually and you’re ahead.
The numbers alone are not reason enough to pursue this strategy.
How long till you retire
Superannuation is Australia’s main system of individual savings for retirement, it’s compulsory and the bulk of contributions are made by an employer but additional contributions can be made by the individual.
When contributions are made to a superannuation account they become restricted to withdrawals until the earlier of age 60 and retired or age 65, this is known as ‘preservation’.
All of your contributions that you save to super will be preserved until you retire which means the younger you are the attraction of saving to super will be much lower.
There is an obvious danger too that preservation adds to a contribution strategy and that is the lack of liquidity. This means that you’ll be unable to withdraw the money in the event of an emergency. If your fridge needs replacing, hot water system fails or your car gets a case of terminal wobbles then you have zero ability to take those funds back from super.
Regardless of how the numbers stack up, if you’re a long way from retirement and preservation age then adding money to super can be a very restrictive and limiting strategy.
Interest is dead money
Low interest rates enable us to borrow more without raising the amount that we’re obliged to make in monthly repayments. Over time though, even low interest rates can compound against you into unfathomable amounts.
A sobering fact is that we pay more interest today in a time of record low interest rates than those households did during the period of record higher interest rates (eg. 20%!).
Low interest rates are a trap for households trying to get ahead – you get nothing back for them, they don’t reward you with a bonus just for making repayments and they don’t actually make you smarter just because you have a loan that’s full of them.
All interest is dead money and the sooner you are doing what you can to reduce them then the better off you will be.
Have a look at some strategies that aid in repaying your mortgage faster such as Debt Avalanche, Debt Snowball and Step Ups. They are repayment only strategies and not combined with complex debt recycling investments.
Before proceeding with a full-on salary sacrifice to super arrangement, check out some ideas to reduce your debt first, particularly if you’re over 10 years until retirement.
Plan your strategy and make it happen
Use whatever tools you can to work out what the best strategy for you is, it could be a piece of paper, an excel spreadsheet or a financial adviser and see what the hard numbers say for you.
Depending on your age, contributing to super will often be the one that wins out but remember the risks of liquidity mentioned above.
You don’t need to do just one or the other, making a combination of both can often give you financial rewards as well as backup options in the event of an emergency.
The road to your financial freedom is winding and foggy but as long as you keep putting one foot forward and stick to your plan you’ll always be one step closer.