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Why it is not always smart to pay off the mortgage

Pay mortgage or not

Aussies are often urged to repay the mortgage first, but what about the opportunity cost of potential gains from other investments? In the interest of investor choice, here’s a guide to the pros and cons.

Paying off the mortgage

Paying off the mortgage first may seem an attractive option particularly given that the interest payments are not tax deductible, unlike borrowings for an investment property or shares.

However, with credit card interest rates often topping 20 per cent, repaying other debts first could be a superior option to paying a mortgage at rates of around 5 to 6 per cent.

Pro: Paying off the mortgage generates a risk-free return.

Con: There are more expensive debts and potentially higher returns available elsewhere.

Saving more money

Save extra or consider refinancing to consolidate other higher-rate debts into the mortgage. The extra funds could then be invested elsewhere, such as into high rate term deposits.

By reinvesting the interest earned, the funds will grow through the power of compounding. For example, an initial deposit of $1000 invested at 5 per cent and topped up with an extra $500 a month would grow to $208,000 after 20 years.

However, if you are near retirement and are not currently salary sacrificing to super, it can be worthwhile making concessional contributions that are taxed at just 15 per cent. Upon retirement, the contributions can be used to pay off the mortgage.

Pro: Generate a pool of savings for future investments, education or holidays.

Con: Discipline required to save money regularly and the effects of inflation and tax.

Borrowing to invest

By using any existing equity in your home as well as spare funds to increase your borrowing capacity for property, shares or other investments, you may also benefit from tax concessions.

One strategy available is using an interest-only loan for an investment property, earmarking the savings to pay extra on the home loan while maximising the interest deductions.

With the benchmark S&P/ASX200 index posting a 17 per cent return in fiscal 2013, investing in shares is an attractive option to generate gains. Over the 10 years to December 2012, Australian shares outperformed all other asset classes by earning 8.9 per cent a year before tax, compared to 6.5 per cent for residential investment property.1

Pro: Potential for higher returns and benefit of diversification.

Con: Borrowing to invest can generate big returns, but there is also a higher risk than putting the money in the bank or elsewhere.

While focusing on the mortgage may seem sensible, there may be far more rewarding investments available and with tax benefits too.

Have you already considered alternative investments to paying off your mortgage?

[Sources]

1 http://www.asx.com.au/documents/resources/ASX_Report_2013.pdf