Mortgage or Super?

Are you better off reducing your mortgage or contributing to super?

A lot of people ask this question. Unfortunately, as with many wealth management decisions there is no straight forward answer. The appropriate choice depends on a number of issues, some of which we address in this article.

The obvious starting point is to look at the numbers. Assume you have 15 years until you can access your superannuation benefits free of tax. You have a mortgage that is costing you 7.0% a year (after tax) and a small amount of super. Over the next 15 years, you expect to have at least $13,375[1] a year of surplus cash flow.

What should you do with this additional surplus?

We assessed two scenarios:

Scenario 1 assumes that you use the $13,375 p.a. surplus to make additional payments to your mortgage.

Scenario 2 assumes that you contribute $25,000 a year to super, as salary sacrifice or as a personal tax deductible super contribution. As a result, your surplus after-tax cash flow reduces by $13,375 a year. We have assumed you are on the top marginal tax rate.

We also assume that you take no additional investment risk in your super account. In other words, you invest the additional after tax super contributions in cash (earning a rate 5.0% per annum).

At the end of the 15 year period, your situation is projected to have changed as follows:

Scenario Comparison	Scenario 1	Scenario 2	Benefit of
	Repay the	Contribution	Scenario 2 over
	Mortgage	to Super	Scenario 1
Additional Loan Balance Reduction	$420,882	$0	($420,882)
Additional Super	$0	$529,346	$529,346
Total	$420,882	$529,346	$108,464
Rate of Return (After Tax)	7.0% p.a.	10.2% p.a.	3.2% p.a.

 

The repayment of the loan will earn you a healthy 7.0% p.a. (after tax) with no risk. The super strategy, however, will earn you 10.2% p.a. (after tax) with the same risk.

Based on this comparison, you are clearly better off using your surplus cash flow to make pre-tax contributions to super rather than repaying your mortgage.

But the numbers alone may not be the only consideration …

There may be other issues to take into account, including:

1. How much flexibility do you need or want in your affairs? To obtain the tax benefits of contributing to super you need to be confident of your future cash flow. You don’t want to experience a lack of cash when you need it most. An investment in longer term planning can help you make the decision with confidence;
2. Your long term super contribution strategy. The “use it or lose it” nature of super contribution limits means that you cannot delay making contributions until just before retirement. Imagine directing surplus cash flow towards the mortgage only to find that you have significantly underestimated your annual cash flow surpluses. You may now find that your ability to contribute to super is undesirably restricted;
3. Don’t forget about legislative risk. While the recent trend has seen superannuation improve in attractiveness, this may not always be the case. The rules can change, invalidating an earlier decision;
4. Don’t unwittingly expose yourself to more risk than you need to. If you choose the super contribution alternative over the mortgage reduction option and invest the proceeds in growth assets, you increase your risk exposure. You are effectively funding the super contributions by using non-deductible debt (i.e. by choosing not to repay it). So, the strategy has an element of gearing to it.
   If you want to increase the certainty of the strategy paying off you need to direct the additional super contributions to low risk assets. Investing in higher risk assets will increase the chance that you may end up worse off; and
5. Don’t ignore the emotional burden of debt. Despite the mathematics, some people will sleep better with less debt. While it may have a financial cost, the emotional pay off may be greater.

 

Take a comprehensive and long term view

The mathematics suggest it’s better to make pre-tax contributions to super, even if they’re funded by non-deductible debt. Yet there are a lot of other considerations to take into account.

Often, the numbers based answer may not be appropriate in light of your broader personal circumstances and objectives. Also, the more qualitative factors (e.g. the emotional burden of debt) may outweigh the purely quantitative factors.

Potential future opportunities (and problems) are revealed from a taking a comprehensive and long term view. In our experience, decisions that are thorough and specifically applied to your affairs not only prove to be less complex and less costly, but also produce results that are far more likely to achieve your objectives.

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[1] Why $13,375? This is the after-tax cash flow you would derive from $25,000 of pre-tax income (assuming you pay tax at the top personal marginal tax rate). $25,000 is the maximum annual tax deductible super contribution for a person aged less than 50.