In the face of the cost of living crisis and high interest rates, many people have less surplus cashflow (income after expenses) at their disposal. They might have high expenses or large financial commitments that consume all their means. However, if you are fortunate enough to be in a financial position where you have strong surplus cashflow at your disposal, you have a choice to make regarding how you use it. A common dilemma is whether to use surplus cashflow to pay down debt or to invest.
Focus on repaying debt?
Most people’s retirement goals involve owning a home outright, so ensuring their home loan is paid off by retirement is common. We agree with this notion, and we think this is particularly important because it is a non-deductible debt and it is secured against a personal asset that is not income-producing (your home). Ideally, you do not want to be carrying the mortgage expense into retirement.
Once your home loan is repaid or there is a plan in place for it to be repaid before retirement, the focus then shifts to investment debt, which is tax deductible and secured against an asset which is income-producing, typically an investment property.
Is repaying debt too lazy?
The concern with paying down investment debt is that the interest rate, on an after-tax basis, does not usually represent a great return on investment, arguably not as good a return as investing the surplus cashflow in growth assets.
For example, an investment loan with an interest rate of 6.5%, which is fully tax-deductible, to someone in the top income tax bracket (paying 47% tax), represents an interest rate on an after-tax basis of circa 3.45%. To them, 3.45% is the after-tax return investment from allocating surplus cashflow to paying down investment debt. Therefore, the question is; if you were to instead invest your surplus cashflow in growth assets such as shares (either inside or outside super), would you be likely to receive an after-tax investment return greater than 3.45% per annum?
Investment opportunity cost
Historically, the resounding evidence suggests you would. As a benchmark, the Vanguard International Shares Index Fund (tracking the MSCI World Index) has returned 7.55% per year (before tax) over the last 27 years, which consists of 2.92% income and 4.63% capital growth. If we deduct income tax from these figures (for someone in the top tax bracket), the after-tax investment return is ~6.17%. Further, if we deduct income tax and capital gains tax from these figures, the after-tax investment return is ~5.09%, which is still higher than ~3.45%.
However, it is important to note that debt reduction as a strategy provides a guaranteed return almost immediately, whereas investing in the share market is not guaranteed, it comes with risk, and it requires a long-term investment horizon to realise adequate returns. The value of a risk-free investment return should not be understated.
Maintaining gearing is often more economical
The other concern with paying down deductible debt is that it erodes the benefits of negative gearing. Preserving the negative gearing on an investment property whilst you are working, will typically result in less income tax payable during your working life. Maximising negative gearing benefits helps reduce the holding costs of an investment property, delivering two key advantages. First, it increases your internal rate of return (as Stuart explains here) because the property requires less out-of-pocket expenses. Second, it frees up cash flow, allowing you to invest in other opportunities, such as maximising your super contributions, for example.
However, the problem here is that once you retire and your income significantly reduces (if not completely), the negative gearing benefits significantly reduce too, and the after-tax holding cost of the investment debt increases.
Invest now, repay later
A strategy that some people adopt is to accumulate a share portfolio rather than repay tax-deductible debt, then progressively sell the shares once retired to repay any remaining debt. This strategy works well in theory, but the major concern is the timing risk. The share market could crash right before you plan on selling the shares. Liquidating a large share portfolio in one year comes with risk as well as capital gains tax outcomes that are not ideal. Ideally, getting a property to be cashflow neutral by retirement should be the aim, rather than paying off the debt completely, and using additional surplus cashflow to invest elsewhere.
To explore the impact of different surplus cashflow strategies in the lead-up to retirement, I have run some calculations in the following scenario.
Let’s assume someone is 50 years old and plans on retiring in 10 years’ time at age 60. They earn an income of $300,000 per annum, they have a surplus cashflow of $60,000 ($5,000 per month) and they own an investment property worth $1,000,000 with $1,000,000 of debt owing against it. For simplicity, let’s assume they don’t have any non-deductible debt or other assets. Let’s also assume the investment property has a gross rental yield of 2.5%, a capital growth rate of 6% p.a., typical investment property expenses (such as management fees, rates, insurance, maintenance, land tax etc.) and a typical interest rate which experiences three interest rate cuts over the next 4 years. To make a fair comparison, let’s also assume the share market experiences 6% capital growth and 2.5% dividend yield (70% franked) per annum.
Over the next 10 years, some of the options available to this individual are to allocate their surplus cashflow 1) 100% to debt reduction, 2) 50% to debt reduction & 50% to share investing, 3) 100% to share investing and 4) 100% to share investing inside super (via non-concessional super contributions). The table below illustrates the outcomes of these strategies by the time they retire in 10 years.
As you will see, the total tax paid over 10 years is higher because of simply paying down their deductible debt (eroding the negative gearing benefits) and their net asset position is lower, even on an after-tax basis. In this scenario, it would be reasonable to argue that investing surplus cashflow has put this individual in a stronger position at retirement, and utilising the tax-friendly environment of super to invest would further improve their position.
By not repaying any debt, the capital growth alone brings the property’s Loan-to-value (LVR) ratio down to ~56% which still leaves this property with a pre-tax negative cashflow of ~$35k. Whilst there is dividend income and franking credits from the share portfolio of ~$27K to offset some of the negative cashflow, striking a balance between debt reduction and investing to achieve an outcome where the property is able to “wash its own face” would be ideal.
Planning for the future is important
Projecting the future cashflow of an investment property is an important exercise for any investor because it allows you to estimate how much of the loan you should repay to get the property close to cashflow neutral by retirement, and therefore how much you can invest elsewhere.
Putting yourself in a position where your retirement assets are diversified across asset classes and ensuring you have liquidity buffers will set you on a strong path to retirement.
How will you allocate your cash flow in 2025 and beyond?
