A common question I get from clients with surplus cashflow is: “should I put extra money toward my mortgage or contribute more to my superannuation”. In this article, I analyse this trade-off.
Background
The common practice is for most people to wait until their home loan is paid off before making additional voluntary superannuation contributions. However, this may not always be the optimal approach.
Our analysis suggests that those who have the capacity to pay more than the minimum on their home loan, could be better off directing their spare cashflow to making additional concessional contributions (CCs) into super instead. Why? Because CCs can be a more tax-effective use of surplus funds.
In some cases, you may come out ahead with the ‘make extra contributions’ strategy, despite modest investment returns in super. However, to make this strategy worthwhile you need to be prepared to take some degree of investment risk.
Using Cashflow More Tax-Effectively
Home loan repayments are typically funded with after-tax income.
Concessional contributions: made with pre-tax income, either via a salary sacrifice agreement, or claiming a tax-deduction on the personal contribution.
CCs can enable you to use your surplus cashflow more tax-effectively. This is illustrated in the table below, which compares the net amount that could be used for: making CCs vs repaying a home loan, based on $10,000 in pre-tax cashflow and various marginal tax rates (MTR) of 34.5%, 39% and 47% (including Medicare levy).
The outcome is determined by the difference in the tax rate inside and outside super.
For example, if your taxable income is between $120,001 and $180,000 (39% MTR), with $10,000 in surplus pre-tax income:
- a net loan repayment of $6,100 could be made ($10,000 minus $3,900 tax), or
- a net amount of $8,500 could be invested in super ($10,000 minus $1,500 which is the 15% tax inside super).
That equates to a benefit of $2,400 by making extra super contributions ($8,500 minus $6,100).
| Taxable Income | Home loan repayment | Net Super Investment¹ | Benefit from investing in super | ||
| Marginal tax rate² | Tax payable | Net loan repayment | |||
| $45,001 to $120,000 | 34.5% | $3,450 | $6,550 | $8,500 | $1,950 |
| $120,001 to $180,000 | 39% | $3,900 | $6,100 | $8,500 | $2,400 |
| $180,001 + | 47% | $4,700 | $5,300 | $8,500 | $3,200 |
² Includes Medicare Levy
Long Term Comparison
I have modelled the potential benefit of allocating $10,000 of pre-tax income into super vs paying off the mortgage, over a 10 year period and also a 20 year period.
In the table below, the ‘Value added after 10 years & 20 years’ rows, represent the cumulative value of $10,000 p.a. invested in super, considering investment returns and tax savings derived (in the super column), as well as the cumulative interest savings resulting from paying an extra $10,000 to the mortgage, considering different marginal tax rates (in the mortgage columns).
The ’Added benefit in super’ row reflects the difference between the outcomes of investing more in super vs paying off the mortgage, at different marginal tax rates.
| Results of investing $10,000 of pre-tax income (5.5% interest) | ||||
| Super | Mortgage | Mortgage | Mortgage | |
| Tax rates | 15%¹ | 34.5%² | 39%² | 47%² |
| Rate used | 7% | |||
| Value added after 10 years | $117,440 | $84,334 | $78,540 | $68,239 |
| Added benefit in Super after 10 years | N/A | $33,106 | $38,900 | $49,200 |
| Value added after 20 years | $348,462 | $228,387 | $212,697 | $184,802 |
| Added benefit in Super after 20 years | N/A | $120,074 | $135,765 | $163,660 |
Note: investment return and interest rate assumptions are provided for illustrative purposes and are not guaranteed.
Other Scenario Results
Although the results presented above favour making additional CCs, it’s important to note that they are based on one set of assumptions regarding interest rate and investment return which have been held constant over the 10 year and 20 year time periods.
Below we consider two other scenarios:
Scenario 1: home loan interest rate increases slightly from 5.5% to 7%
Outcome: the outcome for super still looks advantageous.
| Scenario 1: Results of investing $10,000 of pre-tax income (7% interest) | ||||
| Super | Mortgage | Mortgage | Mortgage | |
| Tax rates | 15%¹ | 34.5%² | 39%² | 47%² |
| Rate used | 7% | |||
| Value added after 10 years | $117,440 | $90,498 | $84,280 | $73,227 |
| Added benefit in Super after 10 years | N/A | $26,942 | $33,159 | $44,213 |
| Value added after 20 years | $348,462 | $268,520 | $250,073 | $217,276 |
| Added benefit in Super after 20 years | N/A | $79,941 | $98,389 | $131,186 |
Scenario 2: home loan interest rate decreases slightly from 5.5% to 4%
Outcome: the outcome for super is significantly more beneficial vs the initial 5.5% home loan rate scenario.
| Scenario 2: Results of investing $10,000 of pre-tax income (4% interest) | ||||
| Super | Mortgage | Mortgage | Mortgage | |
| Tax rates | 15%¹ | 34.5%² | 39%² | 47%² |
| Rate used | 7% | |||
| Value added after 10 years | $117,440 | $78,640 | $73,237 | $63,632 |
| Added benefit in Super after 10 years | N/A | $38,800 | $44,203 | $53,807 |
| Value added after 20 years | $348,462 | $195,046 | $181,646 | $157,824 |
| Added benefit in Super after 20 years | N/A | $153,415 | $166,815 | $190,638 |
Other Considerations
Cashflow Position
Not everyone will have the means or surplus cashflow to allocate towards extra mortgage payments or superannuation contributions. You will need to look at your other financial commitments before considering this strategy.
Liquidity Needs
While additional CCs can help you retire with more super, it’s crucial to consider whether you may need to access these funds, as any amounts contributed to super are locked away until you meet a ‘condition of release’. A key benefit of making extra repayments into your home loan is that these funds are accessible at any time via an offset account or redraw facility.
Division 293 Tax
Division 293 imposes an extra 15% tax on CCs for high-income earners. This is in addition to the standard 15% tax applied to taxed funds, resulting in cumulative 30% tax on these contributions.
Risk Tolerance
Ultimately you need to be willing to take on a moderate level of investment risk to make the ‘extra super contribution’ strategy worthwhile.
Whereas, opting for extra mortgage repayments is regarded as a low-risk strategy as it provides savings through lower interest expenses, and you are not having to take any investment risk. Therefore, if you are conservative and not willing to assume investment risk you may be better off using surplus income to pay off the mortgage rather than increasing contributions to super.
Conclusion
To achieve the retirement lifestyle that you desire, you may need to start making additional super contributions earlier than planned, rather than paying down your mortgage more quickly.
This approach allows you to take full advantage of the concessional contribution cap throughout your workings years, resulting in a more substantial retirement nest egg.
The effectiveness of this strategy will hinge on various factors, including your age, risk tolerance, and liquidity requirements.
Important Information and disclaimer
The information in this document is current as at 11 October 2023 and reflects our understanding of existing legislation, proposed legislation, rulings etc as at the date of issue, and may subject to change.