Nest egg versus the nest

MOST people's first financial priority is to get the mortgage millstone from around their neck and worry about retirement later. But is that the right thing to do?

Nest egg versus the nest

MOST people's first financial priority is to get the mortgage millstone from around their neck.
Pay off the mortgage and worry about retirement later. But is that the right thing to do?

With the tax breaks available on super contributions, some advisers are saying it's more financially savvy to put any extra money into super, rather than pay the mortgage off sooner.

Some are even suggesting it might be worth switching to an interest-only mortgage and using the money you would have paid against the loan principal to boost your super fund.

Once you hit retirement age, or turn 60, you then take a tax-free lump sum out of your super and use it to get rid of the mortgage millstone once and for all. By then you would also have accumulated much more in your tax-free super fund and be much richer than you would have been otherwise.

The only problem, however, is that for many people age 60 is a very long time away.

Salary sacrifice

"From an overall wealth accumulation perspective, there is a very strong argument in favour of switching to super,'' KRA Group financial planner Mark O'Leary said.

"The idea being to move to an interest-only loan and use the money you would have been contributing to reduce the principal as a contribution to your super, then use the faster accumulation in your super to pay off your home loan.''

Because contributions to super of up to $50,000 are tax-free, either in the form of salary sacrifice or as a tax deduction for the self employed, you can save more through super without sacrificing disposable income, Mr O'Leary says.

"If you're a top rate tax payer on 45 per cent and you have $1000 to put against your mortgage, only $550 of that will go towards reducing the debt, whereas if you put that $1000 in to your super, even if you have to pay 15 per cent contributions tax, there is still $850 of savings there, which accelerates you out of the blocks.''

Most taxpayers pay either a 30 or 40 per cent marginal tax rate. This means they need $1.42 or $1.66 of before-tax wages to pay just $1 off their mortgage, with the other 42 and 66 going to the tax man.

The experts suggest you might be better off to keep some of that money from going to the taxman and one way to do this is to stop paying the principal off the mortgage and put that money into your super fund instead.

And another way to do this to ever greater effect is to put that money into your super fund before you pay tax on it.

For example, the principal repayment portion of your mortgage is a $100 per month and your tax rate is 41.5 per cent (including Medicare levy). That means you actually have to earn $170 a month to make that $100 payment.

However, if you salary sacrificed that $170 and put it directly into super, even after paying the 15 per cent contributions tax you will still be $45 a month better off. The reason is because you will be paying less tax on your salary and 85 per cent of the $170 will be going into your super, instead of 58.5 per cent of it (after paying 41.5 per cent marginal tax) if you paid it off your mortgage or paid it into superannuation as an after tax contribution.

When you turn 60 you can then take a lump sum out of your superannuation and use it to pay off the mortgage in full. Under current laws you can take this lump sum tax free.

But there are several important considerations.

Risk versus reward

The first consideration is how your super performs.

Reducing the principal amount of your mortgage means you no longer have to pay interest on that portion of the loan - so any money that you put into an alternative investment, such as superannuation, should earn at least the same rate of return as the interest you are paying (ie your mortgage rate).

Therefore your super fund will need to earn more than about 8 per cent a year, if interest rates stay as they are at the moment. That might be a challenge, even for most aggressive growth funds.

How old are you?

In addition to comparing the rates of return, other considerations include how close are you to being allowed to access your super?

If you put your money into your super fund, you've locked it away until you're 55 at the earliest. But if you pay off your mortgage and you need access to some of that money you can usually redraw it or refinance it almost any time you like.

As well as comparing performance and access to your money, some people simply feel uncomfortable with having a lot of debt - especially having it for 20 years or so.

"It's an emotional issue,'' Mr O'Leary said. "People feel really comfortable getting rid of personal debt. It might be the best strategy financially but if you can't sleep at night because of the mortgage then it doesn't make much sense.''

Others agree on the human or emotional aspect of the decision versus the straight financial equation.

"Numbers-wise, it can be shown that super is a better investment but human nature-wise, my gut feel is to pay off your mortgage as fast as you can," Westpac Private Bank planner Craig Davison says.

Moreover, making the mortgage payment once a month is good discipline.

"Depending how long it is until you can access your super, chances are that with the pressures of life, you may choose not to make the contributions to super that you were intending to.

"With the mortgage, the bill comes from the bank each month - that's a motivating force to put money into your home loan,'' he said.

Another risk, however, is that the further you are from an age where you can access your super, the higher the risk that the rules will change.

If the government starts taxing super withdrawals, for instance, that would change the numbers considerably. The younger you are and the further you are from age 60, the higher the risk.

So, to sum it up. Most of the experts agree, superannuation is the most tax efficient way to save. But the further you are from retirement, the less attractive it is and the better you'll "feel'' about reducing your mortgage - even if you have to use after tax dollars to do it.

Case study
BOB and Angela are both 55. Bob earns $55,000 and Angela earns $75,000 gross each year.

Their mortgage is $185,000 with an interest rate of 7.5 per cent. They plan to retire in five years.
The couple draw up a budget and see that their household expenses, excluding their mortgage, is $55,366 each year.

Currently they are paying their spare cash flow into their mortgage, making their annual repayments $44,484.

With repayments at this level, they will fully repay the mortgage in exactly five years.

Using the new super strategy, they switch to making interest-only repayments on the $185,000 outstanding. These payments total only $13,875 a year.

They opt to put the spare money from the lower repayments and their other spare cash flow into superannuation via salary sacrifice.

Five years later they retire and cash out $185,000 to repay the mortgage in full. Lump sum super withdrawals for people over 60 are tax free. During the five years of the their new super strategy Bob and Angela have accumulated an additional $242,913 in super.

After they pay the mortgage of $185,000 they have an extra $57,913 by using the super and salary sacrifice strategy.

Source: AMP