A lot of people talk up the benefit of having a mortgage in investment property, so you can deduct all of the interest from your income and effectively save yourself when you pay your money to the tax collector. But the way I saw it was that instead of paying money to the tax man, you were just paying the money to the bank in the form of more interest repayments? So my initial thought is to just pay down your mortgage as quickly as possible.
Now you should note that I am only talking about for investment properties, where the interest paid is tax deductible. A PPOR should have the mortgage paid down as quickly as possible to avoid paying a lot in interest over the years.
After looking into it further, I thought I should actually calculate if I was better off paying down the mortgage for an investment property, or instead of paying down the mortgage, investing the saved money elsewhere. Looking at it fairly simply, I first did some hand calculations pretty much as follows.
There is an existing loan of $300,000 at the start, with 7% interest rate, the interest only repayments become $1,750 per month. Saying now you have an extra $2,000 per month in savings, choosing to either pay down the mortgage amount, or invest it elsewhere. Other assumptions include a $120,000 gross salary (after superannuation) and an investment return of 15% gross for the other investment option. Also assuming this is an investment property returning $1,500 per month in rent.
CALCULATIONS
Paying Down Mortgage - After 1 Year
Monthly repayments of $3,750 on a $300,000 loan at 7.00% interest rate
Principal after 12 months = $256,625.00 (using spreadsheet calculations)
Total Rent Earned = $1,500 x 12 = $18,000.00
Interest Paid on Loan = $19,625.00 (using spreadsheet calculations)
Taxable Income = $120,000 + $18,000 - $19,625.00 = $118,375.00
Tax Paid = $31,745.00 (using Australian 2012/13 Tax Tables)
Net Income = $120,000 + $18,000 - $19,625 - $31,745 = $86,630
Plus bonus of reduced Principal = $300,000 - $256,625 = $43,375
TOTAL VALUE = $86,630 + $43,375 = $130,005
Investing Elsewhere after 1 Year
Principal after 12 months = $300,000 (no principal paid down)
Interest Paid = $1,750 x 12 = $21,000.00
Interest Earned on Savings = $3,574.00 (using spreadsheet calculations)
Rent Earned = $1,500 x 12 = $18,000
Taxable Income = $120,000 - $21,000 + $3,574 + $18,000 = $120,574
Tax Paid = $32,560.00 (using Australian 2012/13 Tax Tables)
Net Income = $120,000 + $18,000 - $21,000 - $32,560 = $84,440
Plus amount in investments = $45,010 (using spreadsheet calculations)
TOTAL VALUE = $84,440 + $45,010 = $129,450
As you can see from the bolded values above, there is a benefit to paying down a mortgage in this instance, this is also assuming a 15% return from a different investment, which is of course a very impressive return.
I developed a spreadsheet to be able to calculate a number of different scenarios and by using different variables. The spreadsheet also acts over a 10 year period so you can see a longer term approach. It should be noted that inputing the above variables into the spreadsheet, after 10 years, paying down the mortgage is still a better option. Typically, the higher the interest rate, the better it is to pay down the mortgage, however this is a general statement and it depends on a number of investments.
But looking at the spreadsheet, it shows that paying down a mortgage can actually be a very good place to invest your extra money. This means that while you are looking for a suitable investment, it is a good idea to just park the money into an offset account attached to the loan and pay down the mortgage and reduce the interest paid, until you find a suitable investment which can provide you the required return.
Also please note I have only talked about the purely finance benefits of investing or paying down a mortgage, there is always emotional conditions to consider. For example I myself just prefer to be debt free and to be honest always loathe it when I owe someone money, and owing the bank is no different. So this is just another reason why I typically choose to pay down the mortgage as fast as possible.
If you would like a free copy of this spreadsheet, please click this link Spreadsheets
Great post.
ReplyDeleteI've found the best way to determine what to pay off in almost any situation is governed simply by the real interest rate you are paying. You simply tackle the highest rate until its fully paid and you move on to the next. Typically this would mean Credit cards (after interest-free period) and personal loans first and probably ending with things like HECS loans last (hence why my HECS is only being paid off at the minimum amount).
What gets most people is that they think investment property loans and home mortgages cost them the same amount. But the fact is the real rate you pay is completely different. IP loans are tax deductible and you effectively get a discount based on your marginal tax rate (typically 30% or 37% in Australia).
That fact that your IP loan is really 4.9% p.a and your mortgage 7%, this is the simple reason why you should pay off your house first.
Thanks Marty,
ReplyDeleteOne thing to note with HECS debt is that if you do make a voluntary extra repayment, the government will contribute an extra 10% of your repayment (minimum $500). So for example if you voluntarily repay $1,000, it will effectively knock off $1,100 of your HECS debt.
I did look into this to see if it was worth it, but given a PPOR mortgage with 6.5% interest rate or whatever, it was more beneficial to pay down the mortgage than repay the HECS debt, which only has inflation as the interest rate.