Before you repay the mortgage
Tuesday, 1 December 2009
…you no doubt have probably asked yourself “Am I better to save (invest) or repay the mortgage?”
The correct answer is “it depends”.
The key factors are your income and debt level, amount of cash reserves, the interest rate you are getting on your investments or savings, the interest rate you are paying on your debt, and the inflation rate. Clearing debt while investing is the preferred outcome of course, but each dollar only goes so far.
Some general guidelines though would be:
• If the inflation rate and the mortgage & savings rates are all exactly the same – it doesn’t matter what you do. Either option will have the same effect generally.
• If the inflation rate was higher than the debt rate, then don’t race to repay debt – invest instead. Inflation will push up the property price, and reduce the effect of the debt in real terms. Your investments in other assets should also continue rising in real terms.
• If inflation is lower than the debt rate, and investment and debt rates are about the same – repay debt. Any investment returns will result in paying tax (decreasing the total return) whereas the debt is being paid out of after tax income (for most) people.
These generalisations do not take into account the other variables though. Repaying mortgages is rarely a purely analytical decision. So your preferences, or risk tolerance, may be a crucial factor. Your view of future investment returns, future inflation or capital growth factors, and interest rates may determine the correct balance also.
Perhaps the most crucial factor though is your “liquidity”, or cash position. People don’t eat their houses, but eat they must. And there are life’s little emergencies that require hard currency, such as car repairs or maintenance of the property. And clothing – nakedness is so embarassing for some of us. Therefore people need some ready money too – simply re-financing the mortgage or debt continually can be a very expensive source of emergency or short term funding.
So just as importantly as repaying debt, one should be building (or holding) cash reserves also. Some short term saving is still good – call it emergency funding. Long term saving, such as superannuation plans, also allow the investor to tap into the worlds oldest (and still greatest) financial strategy – compounding interest. While quite boring to watch in the early stages (and seeming to take forever to achieve anything), compounding returns are wonderful. The money that money makes, makes more money. All without an investors personal exertion.
This information is general in nature and should not be used as a substitute for financial advice. Always consult your financial adviser before making any financial decisions.