Should I Pay off My Mortgage? I Wanna be Debt Free?

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Do you dream about paying off your home loan? 

There are several factors to consider when deciding whether to pay off your mortgage:

  • Are you already saving enough to hit your long-term financial goals 
  • Are you maxing out your superannuation concessional limit of 25K?
  • Could you invest elsewhere for better tax-free returns?
  • Do you need to create equity for property investments
  • Do you have other higher interest debts?
  • Are you under mortgage stress?
  • Are you within 10 years of retirement?
  • Could you use a 100% offset account instead?

Your home loan is often the largest debt you will take on.  In the early years, your mortgage can feel like a huge burden and a common desire is to be mortgage-free.  Many busy professionals who have spare cash are time poor and lack the time, knowledge, or interest to consider investing. 

Spare cash is funneled into the mortgage with a strong desire to pay it off or just because it’s the easiest option.

Even if you wait until the mortgage is paid off to invest, you still need to invest time in selecting a financial advisor and /or educating yourself. You may have potentially wasted years of compounding higher returns. 

It is better to spend a little time as soon as you have the spare cash to consider very carefully “Should I pay off my mortgage?” 

Should I Pay Off My Mortgage: Against – Mortgage Rates are at Record Lows.

Currently(July 2020), most owner occupier loans are charging 2.5-3% interest. For up to date interest rates see here.

With rates being currently so low, it seems a great time to invest instead. 

Below is demonstrated change in net worth over 15 years from paying down a mortgage at 3% or earning 7% from an index fund with $1000 / month.  

The difference becomes more marked the larger the contrast between interest rates and stock market returns (unfortunately unknown at time of investment).  The longer time frame you have, the more potentially advantageous the stock market technique.

No investment returns are guaranteed however, so those with lower risk tolerance will prefer a guaranteed 3% saving over an unknown growth rate.

Should I Pay Off my Mortgage? Are you on Track for Retirement?

Check if you are already on track for retirement.  You will need at least a basic financial plan to work this out.  If you’re not yet on target, you will need to take more risk or invest/save more.   

If you don’t want to make a plan yet, consider the most tax effective solution.  Are you already salary sacrificing the concessional cap ($25,000) into superannuation? 

Salary sacrificing the extra to make your contributions up to the cap could save you 15-30% in income tax.  If you have maxed out your salary sacrifice arrangement, you will need to decide if you would be better off investing inside/outside super or paying more into the mortgage. 

Against Paying Off the Mortgage: Inflation

It is inflation that makes the cost of living increase over time.  Inflation is expected to be 2-3% long-term.  This means your real mortgage value is decreasing over time. 

The stock market is expected to grow over the long term (at least 10 years) above inflation.  

Over the years, if your income increases with inflation, your mortgage becomes a smaller and smaller portion of your income.  Finally paying off that mortgage after 30 years is far less impactful on your cash flow than imagined.

A home Loan is one of the Cheapest Debts to Own.

Debt can accelerate households into significant financial hardship through the high interest rates associated with consumer debt. 

If you have debts incurring higher interest rates than your mortgage, these should be the priority to pay off.

Most people should aim to have their mortgage on the home they will retire to paid off by the time they retire.  Taking non-deductible debt into retirement seems like something we’d all want to avoid!  

But in the decades prior, debt can be used to accelerate wealth directly (through leverage) or indirectly (By not paying off your mortgage and investing instead).

Should I Pay off My Mortgage? When You Might Want to…

  1. You are on course for retirement investments already

This is not a competition to collect the most money.  If you have calculated you are already on track for the retirement you desire, paying off the mortgage can fee up monthly cash flow and allow a reduction in working hours of more discretionary spending

2. You are close to retirement

Most experts agree, carrying non-deductible debt into retirement is a bad idea.  You will be far more sensitive to changes in interest rates, and may struggle to refinance loans.  Aim to pay off non-deductible debt in full before retirement

3. You are under mortgage stress from over committing

Mortgage stress is often defined as more than 30% of net income as mortgage repayments.  It probably is far more subjective than that.  If you are struggling to make repayment, tightening belts and putting extra repayments in to give you a buffer is an astute move.

4. You wish to invest in rental properties but don’t have enough equity 

There are several ways to increase equity, but the most reliable is paying the debt down.  The debt can then be converted to deductible debt for your investment property loan.

Pay Your Mortgage Off Before Paying Off These Productive Debts

Deductible debts

  • Loans taken to leverage into real estate can be effective tools for building wealth. The interest and expenses over and above rental income received can be deducted against your primary income.  This reduces your tax burden and can mean these loans are almost half the usual interest rate for those on the top marginal tax bracket.

Student loan debt that is indexed to inflation

  • Student loans (HELP, HECS, UK student loan company) don’t charge interest but increase the loan in line with inflation (2-3%). This is usually below mortgage rates and so should probably paid off last.  You are forced to make minimum repayments, but don’t make additional repayments without considering alternatives (opportunity cost).

If You Choose to Pay Off your Mortgage – Use a 100% Mortgage Offset

Rather than paying the money into your main mortgage account, paying into an offset account preserves full tax deductibility and maximal flexibility. 

Redraw accounts look similar initially, but the bank can refuse redraws if they are concerned about your ability to repay the loan.  They do not have this power over an offset. 

The future is unpredictable.  Everyone should have a cash reserve.  All those whose incomes have dramatically dropped during the COVID-19 crisis (including doctors) were unlikely to forsee this. 

It’s always best to keep a decent emergency fund.

Consider the possibility you may later decide to convert your house to a rental (a popular strategy with professionals who move around a lot for work).  If you have paid down the mortgage loan, you will pay more tax on rental income.  Even if you redraw the extra repayments, the loan paid down is non-deductible unless re-borrowed for deductible purposes. 

If, however, you kept the funds in a mortgage offset, you can withdraw them when you move out and treat the entire amount still owed as tax deductible.

Even for those who don’t plan to move, I think this is worthwhile as circumstances change quickly.

The one issue with a home loan offset is the accessibility.  Having (eventually) $100,000 or more in a bank account has a tendency to make you feel wealthy. 

And feeling wealthy makes me feel spendy!  You can un-link the offset account from your online banking so it’s not tempting you every time you log into your online banking.

Don’t let making the decision of whether to pay off your mortgage or invest be an emotional or lazy one. Your long-term wealth and future options depend on your choices decades prior.  

Assess your situation with respect to all the factors discussed in this article and make an informed decision.  If you want to pay it off here are a few tips on how to get the job done fast

Aussie Doc Freedom is not a financial adviser and does need offer any advise.  Information on this website is purely a description of my experiences and learning.  Please check with your independent financial adviser or accountant before making any changes.

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