Mortgage vs Super – Let’s examine the options
Why do we want our mortgage paid off sooner? For the same reason we make additional contributions to Superannuation. So we can sit by the pool and sip piña coladas in retirement. Paying off your mortgage and contributing to Super are both long-term strategies. If executed correctly, they can put you in good stead for a comfortable retirement.
Think of it this way. You have two separate garden beds and are about to sow your veggie seeds. Both gardens beds are identical bar one slight difference. Garden bed x has access to a little more sun throughout the day compared to garden bed y. Which garden bed would you use?
A similar question arises that many Aussies have asked themselves since Superannuation was introduced under the Keating Labor Government in 1992. Do I make additional contributions to my Super? Or do I use that money to pay down my mortgage?
Let’s take a step back and think this through logically. On one hand, if you extinguish your mortgage early, your disposable income should allow you to make additional contributions to Super. On the other hand, if you make additional contributions to Super every year you could extinguish your mortgage using a lump sum drawn from Super, bearing in mind preservation rules of course.
We generally see people rushing to pay down their mortgage, and then find they hurry to shovel money into Super later in life. Albeit, paying down your loan is fantastic and it makes sense given interest rates are at all-time lows, however depending on your circumstance, you may be doing yourself an injustice.
Making personal deductible contributions or salary sacrificing will receive concessional tax treatment when it hits your Super (this means being taxed at 15% rather than your Marginal Tax Rate (MTR)). While this is one of the most tax efficient ways to build wealth, it isn’t going to work for everyone. The magic happens for people within a certain income bracket. We aren’t talking beer and skittles either. There’s scope to add a few thousand to your sky rocket every year.
To determine which strategy is most beneficial long-term, and before throwing money at the mortgage or Super, we need to take a few things into consideration:
- The difference between marginal tax rates and Superannuation tax rates;
- How much muscle can your money build inside Super compared to your mortgage; and
- the scary, yet wonderful nature of compound interest and returns.
Benjamin Franklin sums it up perfectly, “nothing can be said to be certain, except death and taxes.” He couldn’t be any closer to the truth. While we can’t avoid paying tax, we sure can reduce it. Let’s look at the difference between marginal tax rates and Superannuation tax rates. Marginal tax rates vary from 0% to 45% (not including Medicare levy). While concessional contributions to Super, such as your employer’s Superannuation guarantee (SG), salary sacrificing, and personal deductible contributions are all taxed at a flat rate of 15%.
While contributions and earnings inside Super are taxed, savings on your mortgage interest do not attract any tax. However, despite the 15% tax on investment earnings inside Super, Super will generally still be ahead if the returns are there.
Additionally, in today’s economic environment, mortgage interest rates are around 3.5% to 4.5%, and the return of a typical balanced fund has historically been between 6% to 7.5%.
Let’s take Kate for example. She earns $100,000 per annum and salary sacrifices $16,000 into her Super account. By Kate employing her $16,000 salary sacrifice strategy she would be saving $3,520 on tax. Just like that! How? Well if Kate received her $16,000 income, instead of contributing to Super, prior to it hitting the bank Kate would pay her marginal tax rate of 37% on that income.
Alternatively, if Kate salary sacrificed this amount, she would pay tax at the Super contribution rate of 15%. Every single year Kate does this an additional $3,520 is contributed to her Superannuation, instead of going to the ATO to help fund U.S. junkets for the One Nation Party. Onya Kate.
Let’s bring the above two considerations together.
We’ll stay with Kate, she still earns $100,000 per annum and receives 9.5% SG from her employer. Kate’s employer will be contributing $9,500 into her Super. Kate has $15,500 remaining in her annual $25,000 concessional contributions cap.
For argument's sake, let’s say Kate has a handy $15,500 and is considering doing 1 of 2 things:
Contribute this amount to her mortgage
If Kate contributed this amount to her mortgage, she would be reducing her debt by $9,455 ($15,500 less 37% MTR).
Assuming a 3.5% simple interest rate per annum, the $9,450 would be saving Kate around $330.75 per year in interest.
Contribute this to her Super as a concessional contribution
Kate would be contributing $13,175 to her Super ($15,500 less 15% contributions tax).
Assuming a 6.5% return per annum and 15% tax on earnings, the $13,175 would be earning Kate around $727.92 per year.
It’s clear as mud as to which strategy is more beneficial for Kate.
Compounding interest and returns. According to Einstein, compounding is “the eighth wonder of the world”. Say no more. Compounding interest and returns set the basis for some powerful outcomes.
As shown above, by contributing to Super there is a potential benefit of around $4,000 per year. Let’s say Kate employed this strategy when she was 53 and she is now heading into retirement at the ripe age of 60. Kate will have accumulated approximately an additional $30,000 - $40,000 inside of Super. Again, onya Kate.
However, there is a but. This strategy does not work for everyone.
Do you remember me saying the magic happens for people within a certain income bracket? That income bracket is $60,000 to $160,000.
The concessional contribution cap is limited to $25,000 per year. That means if you are earning around $185,000 per annum the cap starts to narrow. Your employer will be contributing $17,575 to your Super each year through Employer SG. This leaves $7,425 remaining in your CC cap.
Conversely, if you are earning less than $60,000 per annum, while your cap is still wide open it might be difficult to find additional money to contribute to your mortgage or Super.
Delving even further, if you are earning between $18,201 and $37,000 your MTR is 19% (not including Medicare Levy). Contributing concessional contributions to Super will only be saving you 4% on your MTR.
Going back to the veggie garden. If I have access to two identical garden beds, and I know one garden bed will yield a higher return on investment, I know which garden bed I’d be using moving forward. The one with more sun right!?
Before employing any strategy, it is extremely important to understand if it is right for you. Seeking a professional opinion from a qualified financial planner will give you certainty in your decision making. Please come in and talk to us if you have any questions.