The changes to Capital Gains Tax in the recent Federal Budget has changed the equation when deciding whether paying off your mortgage or investing has you better off.

In this episode of Investing Compass, Mark and Shani discuss how the hurdle rates have changed for investors, and how to work out the right path forward given your tax rate and mortgage circumstances. They explore the typical hurdle rates for investing to be more attractive than paying off your mortgage in and out of superannuation, and across Marginal Tax Rates (MTRs).

You can find some of our latest insights on mortgages and property below:

Future Focus: Make your mortgage tax deductible. Debt recycling can be an attractive strategy for those on higher marginal tax rates. I run through how to know whether it is right for you.

Future Focus: The decisions that make a difference to your mortgage. The trade offs for key decisions with your mortgage.

Young & Invested: What happens if property prices go backwards? Could a generation of new buyers could be left trapped if the market turns?

Future Focus: The tax-free returns Aussies are taking advantage of. There are smart ways to take advantage of your offset account, but balance is the key.

You can find the transcript below:

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances, or needs.

Mark LaMonica: Well, Shani, you were on leave last Thursday.

Jayamanne: Yes. And I do want to talk about this. But continue.

LaMonica: Okay. I was going to say, so what I did, we’ve had a lot of Will chatter on the podcast lately. I went, Will is part of our Morningstar basketball team, as are Tiger and Sim are other teammates. I went out there and I watched them play.

Jayamanne: Did they win?

LaMonica: Oh no. They did not win. One of the guys, he missed it, but one of the guys tried to dunk the ball on the other team.

Jayamanne: On our team.

LaMonica: No, no, no.

Jayamanne: No.

LaMonica: The other team that we were playing. Which was interesting. And we had in the league, you have to have two women on the court at all times. And the women have to guard each other. And we only had one woman show up. So you have to play down a person. So our team only had four people on the court. The other team had five.

Jayamanne: Well, no wonder we lost.

LaMonica: But what did you want to talk about?

Jayamanne: Well, I want to talk about. So I went to Tassie, and which we spoke about before on the podcast. And we like when you go on leave, you really want to forget about work.

LaMonica: Do you?

Jayamanne: Yes. Do you?

LaMonica: I mean, I want to. But I don’t.

Jayamanne: And so we met one of my husband’s siblings, his sister, in Tassie. She was staying at a particular hotel. And we went down to the lobby, and you were in the lobby with your wife.

LaMonica: Yeah, I was checking in. You knew I was going. It wasn’t like a surprise.

Jayamanne: No, but what are the chances? That hotel, that time.

LaMonica: Yeah, maybe. I mean, we came a day later. And you know how you leave and you just like want to get to the hotel and then get to the bar, at least if you’re me. And there you guys were.

Jayamanne: It was like 10 a.m., but yeah.

LaMonica: By the way, Shani had definitely already been at the bar when I ran into her.

Jayamanne: I had, Yes.

LaMonica: So let’s get into the actual podcast. We’re going to revisit a topic that we’ve covered before, Shani, but we do think it’s an important one for investors, and there have been some recent changes that may impact the approach that people want to take. So why don’t you remind people of those changes, Shani?

Jayamanne: Okay, so the changes we’re referring to are the changes to capital gains on investments, which was recently passed by Parliament.

LaMonica: Yes, and there were some other changes as well. So those are changes to negative gearing on newly purchased non-new investment properties, and then of course getting mortgages in a self-managed super fund to purchase property. But we do want to be clear that the issue that we’re tackling today is if you should pay down your mortgage on your primary place of residence, or if you should invest. So, in one sense, we’re going to ignore the implications from those self-managed super fund changes and negative gearing changes, but we also need to address their possible impact on housing prices. So a lot to cover today, Shani.

Jayamanne: Yeah, we have a lot of ground to cover, but we are going to start with something relatively simple to calculate, and that is the savings from paying off your mortgage or putting additional cash into your offset account.

LaMonica: All right, we’re going to provide a little bit of background on mortgage. Mortgages, I think most people should know this, but a mortgage is something called an amortizing loan. That means that each mortgage payment, a portion goes to pay interest that you owe the bank, and then a portion goes to principal, which pays back that outstanding balance on the loan.

Jayamanne: And over the life of the loan, the amount of each payment that goes to interest and principal changes. At the start of the mortgage term, most of the payment goes to interest. At the end of the mortgage, most of the payment goes to principal.

LaMonica: So in a 30-year mortgage, it takes around 19 years for more than half of one of your payments to be directed towards principal. The proportions that go to principal and interest matter. Interest is just a cost for borrowing the money. Principal increases the amount of the house that you actually own.

Jayamanne: Making additional payments on a mortgage has the effect of accelerating the path along the amortization schedule. Extra payments go to principal, which shortens the length of the mortgage and ultimately reduces the amount of interest paid.

LaMonica: And the total amount of interest saved is based on your personal circumstances. So you do need to do this yourself. But the good news is there are tons of online calculators you can use, but the level of interest you’re paying, that interest rate matters. The higher the interest rate over the course of the loan, the more the savings will be from prepaying. In many cases, this is just an estimate, right? Because people have variable rate mortgages and that interest rate will change over the lifetime of the loan.

Jayamanne: And we would encourage you all to find a mortgage calculator and play around with it. You can do both a lump sum or one-time payment or model out additional payments to your mortgage over time. But we also want to talk about some other personal circumstances that do come into play. The first is how long you plan on owning your home. For example, if you have a $1 million mortgage, 6% interest rate, and 30 years left on your mortgage, a $10,000 lump sum prepayment will save you around $45,560 over the life of your loan.

LaMonica: But of course, you won’t get $45,560 of savings if you sell your home in five years. That number will obviously be less. That is why we want to think about the savings not in dollar terms, but in an annual percentage, because ultimately there’s an opportunity cost to prepaying your mortgage. So in this case, the $10,000 prepayment, you could of course do other things with that money.

Jayamanne: We also want to talk about housing prices for a minute. Technically, housing prices aren’t a consideration for paying off your mortgage. If you buy a house for $1 million and sell it for $1.5 million, it doesn’t matter if you put that extra $10,000 in. If you did, you will get it back instead of the money going to the bank. If you didn’t, you still have the $10,000. So all that matters is how much you have saved on interest and how much you’ve made off that $10,000.

LaMonica: But we also know that residential housing prices are on people’s mind. So if you own a house, you still have that exposure to real estate, and that isn’t going to change. But over the longer term, if you intend to pay off your mortgage, you may want to diversify your financial outcomes to something like the share market. So I know people are thinking and making these trade-offs.

Jayamanne: In that case, the long-term return of real estate will matter because of the opportunity cost of not getting money into the market. As I’m sure everyone is aware, house prices have historically gone up significantly, especially in capital cities.

LaMonica: Now, it’s hard to know exactly what’s going to happen because frankly the government’s making some contradictory statements. But the original purpose of the tax changes was to help with housing affordability. There are obviously a lot of factors that impact housing prices, but they have come down since these changes were announced. It’s been a very short period of time, though. I do need to say that. So in June, median national housing prices have fallen 0.9%. Prices have dropped 1.1% in Sydney, 1.4% in Melbourne, and 1.9% in Canberra, despite the locks are being there. Remind me of the name?

Jayamanne: Dickson Noodle House.

LaMonica: Dickson Noodle House, yes. So the modeling that the government put out, along with these taxing changes, still showed growth in housing, just showed slower growth in housing prices. So we do have to see what happens, but I know some people are unnerved by this.

Jayamanne: The point is if you pay down your mortgage, you’re always going to save on interest. But depending upon when you are selling your house, there could be an impact on your total wealth over the long term far after you’ve paid off your mortgage.

LaMonica: So let’s get back to these interest savings. An approximation for the savings if you pay down the entire mortgage is the interest rate on your loan. So this will, of course, vary if your loan resets over the time that you own the house. But that isn’t the hurdle rate you need to beat with an investment, and that is because of taxes.

Jayamanne: For investing to be a better financial move in this scenario, you need to beat the 6% after taxes. And this is where things get tricky. In our original podcast, we modeled out a certain scenario of an investment return that consists of both income and capital gains, which is subject to a discount.

LaMonica: And the point was when we originally did that that there are several assumptions that you need to make about taxes to figure out or to estimate that pre-tax hurdle rate, and that’s gotten more complicated. So the new CGT approach that just became the law really changes up that discount. So an easy assumption to make initially is that you hold an investment for over a year and you get that 50% capital gains discount. But now you have to estimate how long you’d hold something and estimate the inflation every year to figure out what that discount is, and that’s hard.

Jayamanne: And what makes it even harder is that if you have a long time left on your mortgage and plan on living in your house forever, you need to not just assume you will hold each investment for more than one year to get a discount on capital gains, but have to make an assumption on how long you hold each investment over that time period and inflation.

LaMonica: At a certain point, the assumptions you need to make just become too outlandish to make them valuable. But we’ll give you some tricks. The first is if you have a choice between paying off your mortgage and making a concessional contribution to super, it almost always pays to put that money in to super, invest in growth assets instead of paying off your mortgage. That’s because you’ll save tax on your income, which will be discounted to 15% from your marginal tax rate, and you will pay a lower tax rate in super, which is still eligible for the original capital gains discount.

Jayamanne: And you originally modeled this out in your article, and those figures stand with a 6% interest rate and a house held for 11 years with an assumption that housing prices will increase by 7.1% a year. The hurdle rate for somebody in a 32.5% marginal tax rate was 3.4%, 1.9% at a 37% marginal tax rate, and minus 0.66% in a 45% marginal tax rate.

LaMonica: Yeah, so you can tell if you are a high income earner, if you’re in a 45% tax rate, you can’t lose by making a concessional contribution. So I did make some assumptions around holding periods and the amount of the return that came from dividends versus capital gains. But as you can see, it almost always makes sense to invest in that scenario.

Jayamanne: Especially if you do hold for the long term. We should say that long-term holding periods are vital if you are going to invest, especially if you’re going to make this choice.

LaMonica: All right. So that move is on that moves us on to what happens if you’re investing in a taxable account. So given the 30% minimum tax and the fact that under many scenarios, investors will pay higher capital gains taxes. I do have some suggestions for investors to estimate how much tax they will pay on their investment. So we’ll start out with low income investors. So now that can be anybody that’s under 30% or even at a 30% tax rate because that’s the tax rate you’re going to pay. So I would assume if you hold investments for the long term that you are paying 10 to 20% of your total return in tax.

Jayamanne: And in that case, with a 6% mortgage rate, the hurdle rate would be 6.6% to 7.2%. That’s doable over the long term with growth investments, but certainly isn’t guaranteed.

LaMonica: If you are a medium income investor, so we’re saying people up from that 30% marginal tax range, so you’ll probably pay 20% to 25%, especially when you, of course, include the Medicare levy on this. That again assumes that you’re holding for the long term.

Jayamanne: And in those cases, you would have the hurdle rate on a 6% mortgage of 7.2% to 7.5%.

LaMonica: And then if you’re in that higher tax bracket, that top marginal tax bracket with the Medicare levy, you’re probably going to pay close to 40% in taxes, maybe 35 to 40% if you hold investments for the long term.

Jayamanne: And that means a hurdle rate of 7.8% to 8.4% at a 6% mortgage rate. That is more risky to accomplish.

LaMonica: So all of this depends on good investor behavior. And as we said, the caveat for every single one of these is holding for the long term. So if you aren’t holding for five plus years, there will be little discount applied to your marginal tax rate when you start looking at the taxes on your gains. So at a 45% marginal tax rate, 2% Medicare levy, 6% mortgage, you would have to earn a return annually over 8.82% in order to get past that hurdle rate, and that is hard to do.

Jayamanne: And we’ve tried to point out that there’s lots of variables involved. There are no variables involved in paying off your mortgage and the savings are guaranteed.

LaMonica: And the important thing is to run through some assumptions to try and make the best decision based on your personal circumstances and consider scenarios where diversification will likely pay off if you’re trying to think about how much money you have in residential property versus the share market. Think about what would happen if you need to sell your house and housing prices actually drop. Going through those things in your head is always helpful. And like most financial decisions, there is no right answer. So we all just try and make the best decisions based on the most likely outcomes.

So thank you very much for listening. We really appreciate it. And my email address is in the show notes plus the links to the articles we referenced.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)

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