Many people question why they should make extra contributions to superannuation when their spare cash could be used to pay down the home mortgage.
With interest rates rising, mortgage prepayments may appear more attractive, but it is worth considering the benefits of additional super contributions to your overall wealth planning.
Making extra mortgage repayments can be a good strategy to reduce the amount of interest paid over the term of the loan and the number of years required to repay a home loan.
Extra repayments result in a guaranteed return equivalent to the interest rate of the loan and is risk free.
Investing spare cash elsewhere would need to generate an after-tax return greater than the interest rate of the loan to be more appealing than mortgage prepayments.
The disadvantage of extra mortgage repayments is the opportunity cost of not investing the cash available. Generally, where the mortgage represents less than 50% of the value of the home, consideration could be given to alternative ways to invest spare cash, such as adding to superannuation.
Extra concessional (deductible) contributions can be a tax effective way to boost an individual’s superannuation balance to allow for a more comfortable retirement. Given restricted contribution limits individuals need the benefit of time to build up their superannuation balance. In retirement the most tax effective place for investment wealth to be is within superannuation.
Consider the example of Steve a professional earning a salary of $200,000 with a home mortgage of $850,000 at a variable rate of 5.67%. Steve has spare cash available each year of $6,000.
If Steve uses the $6,000 each year to make additional repayments on his mortgage ($500 per month) he’ll receive a return of 5.67% and pay down his mortgage four years earlier.
Alternatively, Steve could invest the $6,000 per year into superannuation by salary sacrificing $500 per month. This would result in an annual tax saving of $1,920 including the 15% tax paid on the contribution made to superannuation. This is a 32% return on the $6,000 invested, already putting him ahead of the extra mortgage repayment strategy.
In addition, the investment in superannuation would boost his balance and generate annual earnings. Assuming Steve invests in a growth style portfolio with 80% in growth assets and 20% in secure assets he would likely achieve the hurdle rate of 5.67% a year after-tax over the long-term.
While paying down non-deductible debt should be the priority, it is worth considering the benefits of additional contributions when the mortgage represents less than 50% of the home value. A multi-strategy approach to wealth building can allow individuals to grow both their lifestyle and investment assets.
Things to consider:
- Access to superannuation is restricted until at least age 60. Individuals must be prepared for extra contributions to be inaccessible and invested in superannuation long-term.
- The annual concessional contribution limit is $27,500 and includes superannuation guarantee paid by an employer, salary sacrifice, and contributions claimed as a personal deduction.
- The tax benefit is immediate where contributions are made via salary sacrifice.
- Contributions above the annual limit of $27,500 may be possible where the individual has carried forward concessional contributions available for those with a super balance under $500k.
- Superannuation contributions rules are complex, so it is a good idea to seek advice on the best strategy for you.
This article was first published in Personal Wealth Adviser Issue 5.