With interest rates the lowest we have seen for years (for many, ever), the debate about whether we should be paying down non-deductible debt first or funding additional superannuation contributions is once again topical.
What is the best strategy?
In reality there is no right or wrong answer as it depends on the circumstances for each person or family. Some of the issues that would need to be considered are
- personal income tax rates
- age and how close you are to retirement
- single or family status
- level of debt
- desire for financial security (or certainty of the outcome)
Generally, a younger couple taking on a home loan could be more inclined to pay off as much of the debt as possible if surplus funds are available. Superannuation may not be on their radar given the length of time before they could access funds. If the younger couple are thinking about starting a family the current low-rate environment provides a great opportunity to get ahead in loan repayments should they have to move to one income.
An already established family may want to use the time to get ahead as much as possible with their loan repayments in case unexpected expenses occur in the future e.g. education costs, home renovations or a new family car.
A person, or couple, closer to retirement, however, may view super contributions as the better strategy to maximise returns on investment. Investing more into superannuation, with the ability to generate higher returns compared to repaying a lower rate of debt, could be a more effective strategy particularly if the person, or either of the couple, is on a high marginal tax rate. Salary sacrificing or deductible self-employed contributions, depending on the person's work status, may be a more attractive strategy for utilising surplus cashflow.
Case Study
Maggie has reached her preservation age of 57 years (date of birth: 7 February 1962). Her financial situation is:
Repaying Home Loan First
Maggie could use her surplus cash and increase loan repayments each year by $30,000 up to retirement. It is estimated her debt will be completely repaid by age 65, allowing Maggie to retire debt free.
Maximising Super Contributions First
Alternatively, Maggie could maximise her super contributions by contributing $30,000 each year until retirement into her super fund. Contributions could be a mix of concessional (deductible) and non-concessional contributions. At retirement at age 65, any debt outstanding could be repaid by withdrawing a tax free amount from super.
There may be other strategies available to pre-retirees which may also provide greater flexibility to enhance savings. Strategies such as a transition to retirement pension could be an option if preservation age has been reached. Salary sacrificing into super may be used in conjunction with this pension strategy. Again, at retirement any remaining debt could be paid using tax free withdrawals from super.
Outcome
Our analysis of the two scenarios identifies maximising superannuation as the better outcome for Maggie at retirement, which is what we would have expected.
Again, however, what is right for one person may not be right for another. It really depends on the circumstances and how much 'certainty' is desired by the individual or couple. That is, paying off a home loan and seeing the debt reduce can psychology be more rewarding for some more so than others.
Analysis
Chart A : Comparison of Net Assets at Retirement (in today's dollars)
Chart B : Comparison of Investment Returns over 7 years to Retirement
