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Settle your mortgage or invest the capital?

Dec 10, 2014

By Ferdi Booysen, Head of Strategic Relationships at Old Mutual Wealth

pay mortgage or investThe higher interest-rate cycle begs the question: is it currently better to use your investable funds to pay off your mortgage or to add to your retirement savings?

Recent interest-rate hikes – and predictions that these are to rise further – make the returns you earn on interest-bearing investments somewhat more attractive. But this will be negated by the effect that a higher prime rate will have on your debt.

Although it’s always hard to give an unequivocal answer given everyone’s unique circumstances, generally the cards are stacked against early settlement of your mortgage when compared to increasing your retirement savings.

But there are some points to consider on both sides of the equation in order to best weigh up the odds.

There is no harm in using investable funds to settle your mortgage, but you should not do this at the expense of other savings.

Firstly, it’s essential to pay off other interest-bearing debt. It doesn’t make sense to make extra payments to save on your mortgage interest if you have other debt at a higher interest rate, such as credit cards and retail accounts.

At the current prime rate of 9.25%, an after-tax return on an investment in equities of say 11% compounded over the next decade, outweighs the benefits of the potential savings that could be made by reducing your bond.

However, if interest rates rise by a further 2%, using your excess capital to pay your bond would effectively give you a return of up to 11.25%. The money you would save from this option has the benefit of being tax free.

But there are other significant tax savings you need to consider that you would gain by using the funds for retirement instead.

The tax benefits of using investible funds for your retirement include the ability to deduct a portion of your contribution from your annual tax. The growth you earn in a retirement fund – which includes retirement annuities, pension, provident and preservation funds – is also exempt from income tax on interest, dividend withholding tax and capital gains tax.

A further benefit is that a balanced or equity fund is measured and priced by the market. These investments generate distributions that you can reinvest to buy more units. The longer you invest, the more the compound growth works for you. If you only plan to invest in these once your mortgage is fully paid off, clearly you will miss out on the additional compound growth had you invested earlier.

Opportunity costOne of the biggest mistakes investors make in paying off a mortgage is that they use the funds to upgrade their homes and invest in more property, and often end up with a bigger mortgage and no retirement savings.

Many investors argue that paying off your home provides peace of mind and gives you a significant asset and a healthy balance sheet. Your property asset might enhance your lifestyle, but it cannot pay you an income when you retire unless you plan to rent it out. A primary residence is generally regarded as a lifestyle asset and you only realise your profits (or losses) once you sell it.

Another disadvantage of sinking your investment funds into your mortgage is the lack of diversification of your assets beyond your house. Pre-payment penalties might also apply if you repay your mortgage ahead of the contracted time.

It’s important to understand exactly how much is required for wealth preservation as well as how to best invest any surplus assets.

If the real figures aren’t known, emotional and impulsive decisions will creep in, based on little more than a gut feel, and this may well have detrimental effects on your retirement savings.

2 Comments

  1. If you have excess funds available after contributing 15% of your gross income towards retirement, here’s an interesting question to help decide whether to invest the excess, or use it to accelerate your mortgage settlement:

    Q: Is my mortgage interest rate higher than current inflation?

    If Yes: divert excess funds to your mortgage, you get a guaranteed return above the inflation rate.

    If No: Invest the excess in an inflation beating vehicle.

    Of course even if your mortgage rate is higher than inflation, you can still get returns above your mortgage rate, but they’re not guaranteed.

    (As heard on 702’s The Money Show in response to a caller’s question)

    Reply
  2. Thanks, interesting article.

    This is why I agree with the balanced approach to this debate, as laid out in the SA version of Dave Ramsey’s book “Total Money Makeover” (co-authored by Maya Fisher-French).
    The approach is to first set aside 15% of your gross income towards retirement funding, and only then pay extra into your mortgage.
    In this way there’s diversification, and compound growth gets a chance to work on your retirement funds while you settle your mortgage.
    I’ve always thought it best to get rid of all debt before retirement investing, but I’ve learnt that this would be counter-productive over the long term.

    Reply

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Maya Fisher-French author of Money Questions Answered

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