When you successfully manage your money, you have some left over at the end of each month to spend in an intelligent way. Provided you don’t have high-interest debt to prioritise, you might be weighing up whether to invest your surplus cash or use it to pay off your mortgage more quickly. Which one is the superior financial choice?
Ideally, homeowners will be paying off their home loans as fast as possible, while also contributing to KiwiSaver and putting money into a diversified investment portfolio. But it’s not easy to find the right balance, and the returns can change considerably depending on interest rates.
High interest rates make debt repayment particularly effective
When you make extra payments on your home loan, you pay less interest overall on your loan and you pay it off faster. If you avoid paying interest of 6%, for example, it’s the equivalent of ‘earning’ 6% on your money. But unlike most investments, paying down debt is effectively risk free. There’s no volatility or risk of losing money – you just immediately stop paying 6% interest on those funds.
The sums are impressive: Jo has a $700,000 loan that has 25 years remaining on the term. She is paying 6% interest. If she makes a lump sum overpayment of $10,000, that will save her $33,460 over the life of the loan (assuming interest remains at 6%) and she’ll be mortgage-free about nine months sooner.
With the extra nine months she can put her entire monthly mortgage payment of around $4,500 into a term deposit that earns 5% and turn it into around $40,000. Overall, she’s ahead by about $73,000 on that $10,000 – a great result. (Bear in mind these sums are oversimplified; interest rates change all the time.)
If she invests, it will be hard to match that. For example, she could put that money into something relatively low-risk like an S&P500 index fund, with an average annual return of around 10%. After fees, that net return might be 8%, so after 25 years that will turn Jo’s $10,000 into over $65,000. That’s not as much as she’s saved on her 6% home loan when you add in the extra cash at the end of the mortgage. But the result can flip when interest rates drop.
Low interest rates swing the pendulum more in favour of investing
When interest rates drop, it makes sense to invest more heavily. The cost of debt is low and it’s likely that money can earn a much higher return in a managed investment fund or well-crafted portfolio.
Look at Jo’s situation if her home loan rate was only 3%. She saves just $11,000 over the life of her loan, and the extra nine months of putting her lower $3300 mortgage repayment into a term deposit at 2% gives her just $30,000. A total of $41,000 – suddenly the $65,000 earned by investing that $10,000 is outperforming the loan repayment strategy quite dramatically. (Though she is also $1,200 better off each month due to the lower interest rates, so she could repay debt or invest that, too.)
It’s also worth thinking about diversification and liquidity. By only paying down home loan debt, you have concentrated your investment purely into a single residential home. It’s a fantastic asset to own, but diversification is essential to reducing investment risk. Also, the money you put into debt repayment is locked up; you can’t get necessarily get hold of it quickly in an emergency like you can with most other (non-KiwiSaver) investments.
How can you find a sweet spot?
In real life, it’s not as simple as just plugging numbers into a calculator. Rates and risks change, and your strategy will change too, depending on your personal situation.
Financial advice is the best way to help you find the right balance between investing and mortgage debt reduction. You can also use online calculators to put in your own sums and work out how much difference various strategies could make. It can be quite fun to see where your extra cash can have the biggest impact.