What is the priority: repaying your home loan or investing?

repay or invest

Many people can be very focused on repaying their home loan in full before they begin investing. They are so averse to debt that they cannot envisage doing anything else until their home loan is gone.

However, often this isn’t the best approach to take. At some point, investing is more important that debt reduction. So how do you know when you have got to the point? What factors should you consider?

Question 1: Do you have a sufficient financial buffer?

A financial buffer will allow you to continue paying for living expenses and financial commitments if your financial circumstances change e.g., loss of income. This buffer can consist of access to redraw (i.e., additional repayments into a loan that can be withdrawn in the future, if needed) and/or cash in offset accounts. 

How much buffer you need depends on how secure and predictable your income is, and the extent of your financial commitments.

If your income is unpredictable, I would usually like clients to have a buffer equal to one to two years of expenses and commitments.

If you have substantial commitments e.g., high gearing to asset and/or high gearing to income ratios, then it is prudent to hold higher buffers in this situation i.e., one to two years.

Otherwise, a buffer equal to 6 to 12 months of expenses and commitments should be enough.

Typically, your most important financial goal is to accumulate sufficient financial buffers.

Question 2: Will you be able to reduce debt sufficiently before you retire?

The second consideration once you have financial buffers in place is to ensure you are repaying enough money each month to achieve two things:

  1. Any non-tax deductible (home loan) debt is fully repaid a couple of years before you want to retire/reduce working hours; and
  2. Reduce investment debt to the point that your investments are neutrally geared. That is, the investment income is enough to pay for the interest cost. It is unnecessary to repay all investment debt by the time you retire. It is efficient to retain some gearing. However, you don’t want your investments to be costing you money in retirement i.e., negative cash flow. 

If you are on track to achieve this optimal level of debt reduction, then any surplus cash flow beyond those requirements should be invested in growth assets.

Question 3: How sensitive is your cash flow to changes in interest rates?

A high debt-to-income ratio means that your cash flow is quite sensitive to interest rates, which many people would currently be experiencing. The goal is to reduce debt to a level where your standard of living can remain unchanged almost irrespective of the interest rate setting.

As a rule of thumb, this requires you to reduce your home loan repayments to below 25% of your gross (pre-tax) salary income. Like all rules of thumb, this is a guide only, so it is best to consider your actual cash flow position to ascertain how sensitive it is to interest rates.

Why is investing more generally effective than debt reduction?

Once you (1) have sufficient buffers in place, (2) are on track to reduce debt by a sufficient level by the time you retire, and (3) if your cash flow is not sensitive to interest rates, then it’s likely that investing in growth assets (investments) is more important that making additional loan repayments.

Often, we meet people that have few investment assets, other than superannuation, that have (for example) spent the past 5 years repaying their $350,000 home loan to zero. We think this is a waste – a missed opportunity. In many cases, it is likely that they would have easily repaid their home loan by the time they retired, as their debt was relative immaterial. As such, they would have been much better off beginning investing 5 years ago (e.g., the international share index has returned 11.5% p.a. over the past 5 years) and taking longer to repay their home loan.   

In this recent blog, I discussed why investing is likely to generate more wealth than repaying your home loan. In short, this is because it is likely that the after-tax percentage return from investing in shares or property will be more than the home loan interest rate, on average, over the long run.

What if cash flow is not enough?  

Using your cash flow to repay debt is an obvious strategy. However, for some people, that won’t be enough. In this situation, their long-term investment strategy must address how that will reduce debt sufficiently. Here are some examples of alternative debt repayment strategies.  

  • Sell investments. Selling investments will help you reduce debt. However, the reason we buy investments is to build wealth and we hope to keep them for many decades to benefit from the power of compounding growth. This chart for instance demonstrates that you can more than double your return by holding an asset for an extra 10 years (i.e., 20 versus 30 years). Therefore, wherever possible, I prefer to develop a strategy that does not require any asset sales. That said, sometimes that is not possible. 
  • Withdraw from super. You might be able to withdraw money from your super to reduce debt. Again, I typically like to avoid doing that, because super is so tax-effective in retirement (i.e., zero tax rate on a balance of up to $1.9 million per person). However, if you have more than enough super, then it might be safe to withdraw a lump sum.
  • Downsize your home. If you have accumulated a lot of equity in your home, you might be able to downsize it and use the equity to reduce debt. However, be careful with this strategy because I find that whilst people might downsize accommodation, it doesn’t often translate to a proportionate downsize in value thereby crystalising less equity. That’s because people often want to stay in the same area e.g., they might sell their family home for $3 million and buy a new townhouse costing $2.5 million.

You should have a plan B

You should have a plan B in case you don’t have enough cash flow to meet your debt repayment target. That is, if your cash flow doesn’t turn out to be as strong as you expect, how else will you reduce debt?

Counterintuitively, sometimes borrowing more now is the best solution to having less borrowings in the future. For example, if a client has a very large home loan, often I will recommend borrowing to buy an investment property. The reason being is that at least it gives them something to sell in the future (and they can use the net cash proceeds to reduce debt).

If you have achieved these 3 things, don’t delay investing

If you have achieved the 3 targets below, then it’s very likely that you should begin investing as soon as possible:

  • Have sufficient buffers in place.
  • Are on track to reduce debt by a sufficient level by the time you retire.
  • Your cash flow is not sensitive to interest rates.

Don’t let your emotional aversion to debt prevent you from making the most of your financial opportunities.