Spare Cash - Pay Down the Mortgage or Invest?

One of the significant financial balancing acts for people is the decision around what to do with “surplus” money if they choose to buy a house: Do you pay the mortgage off more quickly or use it to build some investments?

You might also throw extra superannuation contributions into the mix, however with compulsory superannuation contributions currently 10.5 per cent of a person’s income and rising over the next two years to 12 per cent (from the 1^st of July 2025), it is likely that superannuation is accumulating nicely for most people. At the point in time when you are wrestling with the decision of mortgage payments or building investments, you are likely to be some time from accessing superannuation with that money locked up until you are 60. That leaves the two core options for surplus money: extra mortgage payments or investments.

The Mathematics of Extra Mortgage Payments

One of the ‘sacred cows’ of financial wisdom in Australia is to make extra mortgage repayments and pay your mortgage off quickly.

That advice still makes sense.

At the moment, the average variable mortgage rate is around 6.5 per cent per annum, with most people able to negotiate or find a rate a little cheaper than this. This 6.5 per cent rate is important, because it is the effective ‘earning’ a person gets from making additional mortgage repayments. Every extra dollar invested in a mortgage saves (or earns) 6.5 per cent per annum in interest. Importantly, this saving is tax free.

At a basic level, a 6.5 per cent tax free return is attractive and, so, making extra mortgage payments is an effective use of surplus money.

It is worth making a quick comment on the current context of this discussion. When there was an RBA target cash rate of 0.1 per cent for an extended period of time, and mortgage rates below 3 per cent, the ‘earning’ of extra mortgage repayments was much lower. Interest rate increases in 2022 and 2023 have made additional mortgage repayments more attractive.

Investing (And Why Only Growth Assets Make Sense)

Let’s compare that with the basics of using surplus money to invest in growth assets. If we make the assumption that the person in the question doesn’t want the challenge of an investment loan and investment property, they are likely to be investing in a diversified portfolio of growth assets including Australian and global shares.

To get an idea of recent market returns, we can use index funds as an approximation for the ‘average’ investment experience. For the Australian market, Vanguard’s Australian share fund (to the end of April 2023) has returned 7.8 per cent per annum (plus franking credits) over the past 10 years while the Vanguard International share fund has returned 14.1 per cent per annum over the past 10 years.

It is important to note that these returns are before tax, keeping in mind that the benefit of extra mortgage repayments are effectively tax free. That said, assuming a relatively tax effective investment approach that does not create too many taxable capital gains, a mix of Australian and international shares over the past 10 years would have you a little bit ahead of the extra repayment strategy after tax.

If you decide to go down the path of building some investments, it is worth remembering that while you have money borrowed at the mortgage rate, currently 5.5 to 6.5 per cent, it does not make sense to be investing in cash and fixed interest investments. You will not earn 5.5 per cent to 6.5 per cent after tax from a cash account and are unlikely to do so from a quality fixed interest investment, so you are better off either using this to pay down your mortgage (and earn 5.5 per cent to 6.5 per cent tax free) or invest in growth assets. Even if you want to invest in a ‘balanced’ investment fund, it is worth remembering that the earning rate on the cash and fixed interest part of the fund will be less than what you could ‘earn’ by using the money for extra mortgage repayments.

The Stages of the Decision

There is no clear winner in the extra mortgage repayments vs an investing program discussion. The tax-free return from additional mortgage repayments is attractive, while the growth assets are likely to have provided a slightly higher, albeit volatile, return over the past 10 years.

Perhaps, though, there are different stages of managing a mortgage that might help a person make a decision.

Stage 1 – Managing the Financial Risk of a Mortgage

Given the current high cost of housing, most home purchases will be accompanied by a large mortgage. This creates levels of financial risk – how well can higher interest rates be absorbed? What about not having a job for a period of time? 

During this stage it makes sense to focus on repaying the mortgage as the primary strategy until such as time when the extra repayments and the effect of inflation in reducing the ‘real’ value of the mortgage and (hopefully) the increase in price of the property means that the homeowner/s are comfortable that the risk of the mortgage is well controlled.

Stage 2 – Getting Ahead

The second stage, moving to a situation where the homeowners feel that the financial risk of a mortgage is well managed, will largely be down to personal preference. Is that preference to keep paying off the mortgage? To start building investments? A bit of both?

A person or couple who identify that they have $1,000 per month of surplus income can be strategic about how they allocate that: for example, 20 per cent to the mortgage and 80 per cent to additional investments, or the other way around.

Stage 3 – The Background Mortgage

The final stage occurs when the homeowner/s have paid down their mortgage to the point where they don’t have any ambition to reduce it further. For example, on an $800,000 home they might be happy to make no more than the minimum repayments once the loan reaches $200,000. They are happy to let inflation and the minimum repayments slowly reduce the loan further, while using surplus income to build investments.

Conclusion

Interest rate rises make this a good time to revisit the balance between key personal finance strategies of making extra mortgage payments or building an investment portfolio. Both strategies make sense financially, with competing but slightly different benefits, leaving the decision very much to the homeowner’s judgement. However, starting by paying the mortgage down to a level where the financial risk of higher interest rates or coping with a period of lost income is manageable is a good first step, followed by the personal preference as to the balance between extra mortgage repayments or investing.