Hands down the most common question asked in our recent ‘Women and Superannuation’ seminars for Department of Local Government and Communities is:
“I have some extra income at the moment.
Should I use it to pay off my mortgage
or put it into superannuation?”
Spoiler alert: the mathematics is crystal clear on this one, which is why most financial advisors won’t hesitate to reply: “Put it in superannuation”. This fails to account for your emotions and stress levels, which aren’t nearly so clear-cut.
I’ve dedicated the following blog to answering this question, including detailed calculations. I hope you find it useful. If you’d prefer a Cliff Notes version, check out the video instead (or read on below for more details):
SUPER VS MORTGAGE | Hands down the most common question we were asked at our Women and Superannuation seminars for the Department of Local Government and Communities (DLGC) was whether we recommended putting extra cash into the mortgage, or boosting the retirement account.The math is clear, but the emotions aren't nearly so straightforward.Got a #MoneyQuestion? We'd love to answer it – send us a PM 🙂
Posted by Money School on Thursday, August 3, 2017
Let’s start with the maths.
Mortgage vs. Superannuation: the mathematics.
Let’s take a typical scenario to use as a worked example: a 55-year-old with a mortgage balance of $200,000 and a remaining loan term of 10 years. Her costs have gone down, and she’s finding she’s got an extra $1,000 (before tax) per month available.
To complete the calculations, we have to make a few assumptions.
We’ll use an average interest rate of 5.5% for the 10 year term. At the moment, you should be paying 4% or less on a mortgage for your home (if not, please stop here and immediately proceed to asking for discounts). Given rates are at historical lows and have been for some time, it is reasonable to expect that the rate will go up over that 10 years as the economy strengthens. Most banks will still use between 7 and 8% in their long-term calculations, which is reasonable over 30 years. Our timeline is shorter, so we’ll use the midway point between 4 and 7%.
We’ll use average superannuation returns of 6% after fees, taxes et al. This may seem low, but it’s reasonable in the current economic climate. As interest rates rise, we would expect returns to also rise. For now, we’ll err on the conservative side.
We’ll use a top tax rate of 35%. This depends on your income and so will be highly variable between individuals. This bracket is the $37-80k bracket, which is considered ‘average’ in Australia. If you’re wondering why it’s 35% and not the ATO-quoted 32.5%, that’s because I’ve added in the likely levies.
We will also assume that any extra superannuation contributions come in under the cap. If you’re earning $80k a year and your employer is making the minimum contributions, you’ll have around $8k a year going in already. The current cap is $25k before extra tax kicks in, so we’ll be well under that limit in this scenario.
Mortgage base case
The current mortgage is $200k with a 10 year term. Using 5.5% interest, the minimum monthly repayment would be $2,171 per month.
If she stuck with minimum repayments, the mortgage will be paid off in 10 years, when she reaches 65. In total, she will have paid $260.5k to pay off the $200k.
Mortgage with extra repayments
Of the $1,000 per month she has before tax, at a 35% tax rate she’ll receive $650 in her hand. If that goes into the mortgage each month, the repayments jump from $2,171 to $2,821.
With this boost, she’ll pay off the mortgage in 7 years and 2 months, making her age 62/63. To that point, she’s put in an extra $56k. Paying the mortgage off quicker saves money because less interest is charged, so instead of paying $260.5k, she’s paid $242.5k – a saving of $18k in interest.
She can now put the extra into her superannuation and earn 6% on it. For 2 years and 10 months that’s what she does, putting $850 a month extra into super (why $850? See the next section). At the end of that period, she’s added $29k extra to her superannuation, and that portion has grown to around $31.5k.
The interest saved is equivalent to earnings – it’s money she didn’t need to spend – so we’ll treat it as such.
- She put $56k extra into her mortgage and $29k extra into superannuation ($85k total)
- She earned $18k + $2.5k on that money ($20.5k total)
Putting it into superannuation
The major difference between these two scenarios is the amount of extra money she has each month to contribute. When taking it in her paycheck, she’s getting $650 in her hand. If it goes directly into superannuation, she’s getting $850 because the tax rate of 15% on super applies. That’s 30% more than taking the cash in wages, which is why the maths is a stand-out for this case.
By the time she would have paid off the mortgage (7 years and 2 months in), she would have contributed an extra $73k to superannuation, and made $18k on it.
By the end of ten years, she has contributed an additional $102k and it’s grown to $139k.
Comparing the two scenarios
When using the extra money to pay off the mortgage, she received $85k in capital and made $20.5k on it.
When putting the extra money into superannuation, she received $102k in capital and made $37k on it.
This is why it’s so clear-cut. The tax advantage of superannuation makes a huge difference to your capital, and the power of compounding affects it exponentially.
This is why most financial advisors will advise putting extra money in your superannuation, then using the extra growth to pay off the mortgage when you retire and can take out a lump sum tax free.
What gets missed: stress, changing rules and guaranteed earnings
No doubt about it, knowing you own your home outright is a recipe for sound sleep. Interest rate changes, unethical bank conduct and poor job security will no longer keep you up at night. You’ll be safe and secure in the knowledge that whatever else happens, you have a roof over your head.
That knowledge may well be worth taking a loss (which is what you do if you put the money into your mortgage rather than superannuation).
Secondly, who the heck knows what the rules will be regarding superannuation in the future? With growing government debt and no sign of an economic boom on the horizon, politicians are liable to hit impending retirees where it hurts. There may be a tax on your superannuation withdrawals, or restrictions on how big a sum you can withdraw at one time. There are absolutely no guarantees on this stuff.
Finally, please remember that the 6% return on superannuation was a guess. It is entirely possible that returns will be lower, or higher. We have no idea, and no crystal ball with which to tell in the long term what’s likely to happen our economy (though we can have a good guess at the next three years).
What we CAN be confident in is interest on your mortgage. You will be paying it. The sooner you pay off your mortgage, the less interest you will pay. That’s as close as I can get to a guarantee in this scenario. So, do you take the certainty, or the hopeful estimate?
So, how do I decide between mortgage and superannuation?
This is where you have to get personal. Only you can decide what’s right for you, and it may well be that you are willing to take the loss to have certainty around your home. Or, perhaps the maths was so convincing that you’re going the superannuation route.
Either way, I recommend applying the “Sleep Well Test”, which is:
Will you sleep well if you take that option?
And remember, you can always do both. Perhaps you put some into super, and some into your mortgage. Or, you might change your mind in a year or two. Just make it a conscious decision.
Addendum – Reader question: what about the mortgage money?
I love it when people ask questions, they catch me out when I’m wrong. Jess wrote in with this one:
In the paying off mortgage scenario, once Jane Doe finished paying off her mortgage, her monthly surplus would actually be $850 plus $2,171, which is what she was paying towards the mortgage she no longer has. Was this accounted for in these calculations, because for this to be a true comparison, it needs to be.
By golly, she’s right.
I ran the scenario, and here’s what I got (you can see the original in the comments below):
Updated numbers assuming mortgage money now goes to super
You are correct, Jess. She does have the extra $2,171 per month (post tax) from 7 years 2 months in, and that she would be free to put that into super. Good spotting 🙂
It starts to get a bit complicated because of tax caps, but let’s give it a whirl:
- $2,171 post-tax (if the rate is uniformly 35%) would be $3339 pre-tax per month
- With 15% tax, that’s $2,838 per month into super
- With the additional $850, that’s $3,688 per month available to go into super
- She’d hit her contributions cap 4.6 months in (assuming she’s still on minimum contributions of $8k per year, and obviously financial year timing would affect that). It’s rarely worth contributing more than your caps due to tax impact, so let’s assume she stops at her $25k cap.
- Hard to know what she’d do with the extra monthly $2,821 ($2,171 + $650) for the other 20.2 months, so we’ll leave that $57k out.
- Assuming she can spread it across 3 financial years, she can contribute an extra $51k to her super fund in that remaining 2 years 10 months.
- If she starts at month 1, she’ll turn it into around $56k ($5k earnings). You’d start at month 1 and put the max in until 4.6 months, so you got more compounding effect (rather than spreading it across the year).
In that case:
- her capital going in is $56k + $51k = $107k
- her earnings on those are $18k + $5k = $23k.
- she’ll own her home outright and have an extra $56k in super, paying her around $3,370 a year (if she takes the earnings instead of compounding them).
- theoretically she’s had an extra $57k in her pocket after tax, when she wasn’t putting extra into her super fund. Lovely to think it went into more assets, but will exclude that for this purpose.
So, now the two scenarios are:
- $107k capital in (plus $57k elsewhere – spent, invested, who knows)
- $23k earnings
- $56k extra in super, earning $3,370 per year
- $102k capital in,
- $37k earnings
- $139k extra in super, earning $8,360 per year.
Now this is the crunch point.
In both cases, you have your mortgage paid off at retirement, so you own your home outright.
If you have $56k in super versus $139k in super, that’s a 60% drop in capital and therefore income at retirement. Remember, you don’t earn an income from your home. You’re better off from the maths perspective putting it in superannuation.
If you include the $57k that went in her pocket when she paid the mortgage first, at best she’s ended up with ~$113k in capital (ignoring any earnings on that $57k in the 2.8 years she’s had it). You’re still better off from the maths perspective putting it in superannuation.
It’s the power of compounding – waiting till Year 7 to start putting the extra in means you get 1/4 of the compounding time, which has an exponential effect. This obviously has implications for retirement lifestyle too, as less capital means less income.
Thanks for the comment, Jess!
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