Now that home loan interest rates have risen by 4% over the past 13 months, is it still worth investing your surplus cash flow, or should all cash flow go towards repaying your home loan?
Many of my clients invest some surplus cash flow in the share market each month. This has been very easy to do over the past 10 years as interest rates have been relatively low. As such, it was easy for clients to invest as well as make extra loan repayments. However, now that interest rates have risen, it’s important to reconsider how best to allocate your cash flow.
Both savings and returns compound
If your home loan interest rate is 6% p.a., and you repay an additional $10,000 off loan principal, you will save $600 in interest over the next 12 months. If you repay an extra $10,000 next year, your total savings will be $1,200 because you have repaid an additional $20,000 in total. And so, your interest savings compound.
Investment returns also compound. In fact, compounding returns is the most successful way to build wealth. It is important to note that if you can minimise the annual tax that you pay on investment returns, it allows you to maximise the amount that is compounded. To do that, you must invest in a way that generates a proportionally higher amount of capital growth, which I discuss below.
Compare after-tax return with interest rates
Since both options compound, comparing your home loan interest rate with the likely (expected) after-tax investment returns will tell you whether you are better off investing your spare cash or making extra home loan repayments.
Current variable home loan interest rates are around 5.85% p.a. Since home loans are not tax deductible, this is your after-tax saving/benefit from making additional repayments.
The Australian share market index has returned 8.57% p.a. over the past 10 years and 8.96% p.a. over the past 20 years (ASX200 Accumulation index).
Let’s assume the midpoint of 8.75%. This total return should consist of a dividend yield of around 4.5% p.a. and therefore growth of 4.25% p.a. (on average).
The table below sets out after-tax total investment returns (growth plus income) from investing in the Australian share market, after adjusting for all taxes including CGT, franking credits, and the power of compounding.
As this analysis shows, over the long run, returns from investing in the Australian share market should exceed the home loan interest rate by approximately 1.2% to 2.0% p.a. Therefore, you are better off investing your surplus cash flow, not making extra repayments towards your home loan.
Longer term share market gross returns are better than those quoted above. Australian and international share market have returned more than 10% p.a. over the past 4+ decades.
If your taxable income is more than $180,000 (i.e., you pay the highest marginal tax rate of 47%), you would be better off maximising your capital growth return i.e., aiming to generate more growth in return for less income. Investing in international share markets will help you achieve that.
Home loan interest is guaranteed, returns are not
Investment returns are never linier. Whilst I have compared long term returns above, of course, investment returns can vary a lot from year to year. Therefore, there are no guarantees that you will be better off investing over the next 12 months, as short-term returns are impossible to predict.
Consider your personal circumstances
Apart from relative financial returns discussed above, you should consider whether your personal circumstances dictate which option is best for you:
- If your cash flow is very sensitive to interest rates (e.g., you have a high amount of debt compared to your income), then perhaps the safest option is to direct all cash towards debt reduction to reduce your interest rate sensitivity.
- If you expect future changes to your income, such as starting a family, you might be better off building cash savings in an offset account.
- If you are young and/or have little investment assets then building your asset base is a priority i.e., investing.
Fund investing through borrowings instead of using cash flow
Instead of choosing between making extra home loan repayments or investing, why not do both? You can direct all after-tax surplus cash flow into reducing your home loan and borrow to fund your regular share market investing. If you take this approach, obviously your net debt doesn’t change e.g., you repay $5,000 per month into your home loan and draw $5,000 from your investment loan. However, the tax effectiveness of your total debt is improved because you have reduced your non-tax-deductible debt in return for increasing your tax-deductible debt.
In a way, this gives you the best of both worlds. That is, you can reduce your home loan as much as possible whilst continuing to invest. I discussed the merits of this strategy last month here.
Stick to your plan!
I have written before that consistency is far more important than intensity. Investing regularly into the share market for many years works because (1) you develop a regular savings pattern and (2) you spread your timing risk. If you do that consistently over many years, you’ll build a lot of wealth. Stopping and staring i.e., investing spasmodically destroys this strategy.
I invite you to focus on making good long-term decisions. Don’t worry-about figuring out the right thing to do in 2023. Instead, work out the best approach for you over the next 5-10 years and stick to it. This will help you drown out short-term noise and worries.
