Understanding the pre and post tax cost of home loans
Home loans are paid off using after tax dollars. The effective after-tax holding cost of a home loan is equivalent to the interest rate charged by your financial institution. It follows that the pre-tax holding costs can be worked out by the following formula:
Pre-tax cost of interest = Interest rate charged / (1 – Marginal tax rate)
Interest rate charged by bank: 5.00%
Marginal tax rate: 47.00%
Pre-tax cost of interest = 5 / (1 – 0.47) = 9.40%
In the above example, an investment opportunity would need to return at least 9.40% before tax for an individual to be better off than simply reducing their mortgage. Finding an investment that returns more than 9.40% may be possible, but any such investment would not be risk free. The closest thing to a risk-free investment would be government bonds, which currently yield no more than 3.0% (before tax). On a risk/return basis, paying off a home loan provides the optimal solution.
Salary sacrificing into superannuation
Salary sacrificing into superannuation is generally more tax effective than having your salary taxed at your marginal tax rate as long as your taxable income exceeds $18,200. The threshold level of $18,200 is important because that is the level where the individual marginal tax rate scales increases from 0% to 19% (before Medicare Levy). At that marginal rate $10,000 salary would be subject to $1,900 tax, resulting in an after-tax sum of $8,100. If $10,000 was sacrificed into superannuation, then the 15% tax levied on pre-tax super contributions would result in an after-tax contribution of $8,500. In simple terms, the higher your marginal tax rate, the greater the tax benefit as follows:
Salary sacrificing into superannuation versus paying off your home loan
We have shown above that in isolation, salary sacrificing can be tax effective for most individuals. When, however an individual also has a home loan, the choice between increasing home loan repayments or salary sacrificing becomes more complex. This is because we need to take into consideration investment returns and interest rates. This is perhaps best shown by the examples as follows:
Joe earns $150,000 per annum plus 9.5% super guarantee contribution. He has a 25-year $500,000 mortgage. Before mortgage repayments, his living expenses total $30,000. Over 15 years, would he be better off salary sacrificing an additional $10,000 per year into superannuation or increasing his mortgage repayments by an amount that equates his after-tax cashflow?
Under this scenario over 15 years, Joe would be approximately $86,000 better off by salary sacrificing into superannuation rather than increasing his mortgage repayments.
Assuming the same circumstances in scenario 1, except this time interest rates on home loans have increased significantly to 12%. Would Joe still be better off salary sacrificing to superannuation rather than increasing his mortgage repayments?
Under this scenario over 15 years, Joe would be about $32,000 better-off by increasing his mortgage repayments rather than increasing his salary sacrifice contributions.
Individuals on a marginal tax rate of 19% or higher would normally be better off salary sacrificing into superannuation rather than using their surplus cashflow to increase mortgage repayments. As it can be seen above, this will not always hold true. As there are numerous factors that can impact the outcome including investment returns, mortgage interest rates and time horizons, individuals should seek appropriate advice before implementing any strategy.
Copyright © 2018. The information provided is not personal advice. It does not take into account the investment objectives, financial situations or needs of any particular investor and should not be relied upon as advice. While the information is provided in good faith and believed to be accurate and reliable at the date of preparation, we will not be held liable for any losses arising from reliance thereon. We recommend investors consult their personal financial adviser to discuss suitability and application to their individual circumstances. Advisors at Pitcher Partners Sydney Wealth Management are authorised representatives of Pitcher Partners Sydney Wealth Management Pty Ltd, AFS & Credit Licence number 336950.