I reckon that the “number one” question I get from couples is whether it is better to put extra cash into paying off the mortgage, or rather to increase super contributions through salary sacrifice. And since the third option, taking an overseas holiday, is off the agenda for the time being, this question is even more relevant today when household budgets are strong.
With interest rates at record lows, financially, the answer will nine out of ten times be to put the money into super. This rests on a critical assumption about investment returns in super. But, super has its limitations, and there are other reasons to pay down the mortgage.
Let’s look at the pros and cons of each, but first, a recap on how salary sacrifice into super works.
Salary sacrifice is asking your employer to contribute an additional amount into super on top of the compulsory 9.5%. It comes out of your pre-tax wages, reducing your take home pay and rendering you a tax saving.
When these contributions hit the super fund, they are taxed at 15%. But this rate is a lot lower than your marginal tax rate, meaning that that you will get more money into super through salary sacrifice than if you made the same contribution from your take-home (after tax) pay.
Here is an example. Suppose you earn $100,000. On your top dollars, you are paying tax at a rate of 34.5% (including the Medicare Levy). If you take the top or last $10,000 you earn each year as wages, you will pay $3,450 in tax, leaving $6,550 to spend. If instead you salary sacrifice this into super, the whole $10,000 will go into super. The super fund will pay $1,500 in tax, and invest the remaining $8,500. All up, you will be $1,950 better off (that’s $3,450 - $1,500).
Of course, salary sacrifice contributions reduce your take home pay. They are also limited because the contributions count against the $25,000 cap on concessional contributions. For example, if you are earning $100,000 and your employer is contributing 9.5% or $9,500 into super, then the maximum amount of salary sacrifice contributions you can make is $15,500.
The main downside with super is that contributions are locked up until you turn 65 years of age. If you are in your fourties, this is 20 to 25 years and potentially a few “life events” away, and it is possible that the rules might change and make it even longer. You also will not get any credit if you want to borrow to invest - you cannot use your super as security for a loan.
But financially, from a long-term perspective, you should do well. Take for example Australia’s largest super fund, Aussie Super. It has delivered returns averaging 8.77% pa for its benchmark ‘balanced’ fund over the 10 years to 30 June 2020. Since inception, which goes back almost 35 years to 1985, it has averaged 9.37% pa. And while returns have come down over the last few years, these are still pretty impressive numbers.
What about paying off the home loan? Unquestionably, reducing the amount you owe the bank brings enormous emotional relief and can be a real positive for family dynamics. It also improves your borrowing capacity, for example, if you wanted to borrow to buy an investment property or invest in shares. For these reasons, I would never suggest that paying your home early was a bad strategy.
However, in an environment of low interest rates, financially, it is not the smartest strategy. Whereas you can earn 8% in super (assuming Aussie Super and its peers can maintain their long-term performance), the home loan is only costing around 4% and in many cases, considerably less. Both these rates are effectively “after tax” – the home loan is coming from after tax dollars, super returns are after the deduction of tax. When interest rates go up, or super funds lose their shine as an investment vehicle, the decision will become more marginal. At the moment, putting the extra money into super wins hands down. This all said, I expect that most couples would go with the “heart” and pay-off their mortgage first.
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