Home loan interest rates are impacting investment decisions

Investors may be surprised to learn exactly how much is needed to make it a better choice than pumping cash into a home loan.

Higher home loan interest rates are prompting people with mortgages to re-examine their investments and the returns required to make investing better than paying down housing debt. The mechanics of tax and interest mean many investments today must generate more than 10 per cent annually to be more rewarding than pumping extra money into a mortgage offset account or redraw facility.

Mortgages are typically repaid with wages that are after-tax income, while investments can be hit with income tax and capital gains tax, and people should factor this into their finances, money experts say.

For example, if you earn 5 per cent interest on a deposit and pay income tax, the net after-tax return is about 3.5 per cent for average workers and just 2.5 per cent for people on the top marginal tax rate.

MidSec Financial Advisors managing director Nick Loxton said the typical 30 per cent tax rate for workers meant a 6 per cent home loan interest rate was “really costing more, nearly 8 per cent”.

“Every time I pay a dollar off the mortgage, the bank can’t charge me interest on that so I’m getting a guaranteed return of 8 per cent,” he said.

Higher interest rates have made it more important to pay off mortgages faster. Picture: iStock

Selling assets other than the family home could attract capital gains tax, adding up to 3 per cent more to the required return, while investments that did not have guaranteed returns usually carried a risk premium, perhaps another 3 per cent that took the total to 14 per cent, Mr Loxton said.

“Even without the risk premium, it’s still 11 per cent,” he said.

“When interest rates were really low we would say to people “pay off your debt’ but they said no because debt was cheap. We would say ‘you can pay off more because it’s cheap’.”

Mr Loxton said investing was still a good idea, and people who borrowed to invest were able to claim tax deductions and benefit from capital growth.

He suggested having cash available to cover financial emergencies, while investments without tax benefits could be re-examined.

“Your assumptions need to be logical and not those of the fairies or unicorns,” he said.

JBS Financial Strategists CEO Jenny Brown said she usually recommended clients put money into super for its tax benefits, “but when it comes to investing outside of super, it comes down to making sure it’s tax-effective”.

“There is no point investing in cash – you are better off putting money in an offset account to minimise interest,” she said.

Paying extra money off a mortgage gave people more options later, Ms Brown said.

She said some borrowers focused on these home loan-versus-investing tax calculations, but not all.

“It’s a mixed bag – some people think they have thought about all their options but they haven’t. That’s why we say to people ‘go and get some advice’, so you are covering all your bases.”

Mr Loxton said anyone who stepped away from the risk-free returns of cash deposits, guaranteed by the federal government, and paying down mortgage debt “must be willing to accept some level of loss at some point along the way”.

“Do not look through rose-coloured glasses,” he said.

“If you are going to invest, think about what is the pathway to a reasonable return and the probability of that actually happening.”

Originally published as Home loan interest rates are impacting investment decisions