Repaying mortgage wise way to invest

By MARY HOLM

Q. I own a two-bedroom flat in Auckland, on which I owe approximately $70,000. I am at present in London earning good money and sending it home. Thus I have quite a bit of money in the bank.

Should I use this to pay off some of my mortgage, or invest the money in another way, such as a managed fund, term investment or even another property?

A. It's about time we did this old chestnut - repaying a mortgage versus investing - again.

We'll look, first, at the situation for owner-occupiers, and then look at an added consideration for people like you, who have rental property.

The first thing to understand is that paying off a mortgage with an interest rate of x per cent increases your wealth by as much as an investment that earns x per cent.

An example might help. Let's say you've got $20,000. Would you prefer to:

* pay that off your mortgage, reducing your interest payments by $1000 a year, or

* put the money in a risk-free investment that earns $1000 a year, after tax, fees and so on?

If you're rational - as opposed to human! - you won't care which. The two are equivalent.

It follows, then, that if you can find a risk-free investment that pays you more than the mortgage interest rate, that's the way to go.

If not, repay the mortgage.

But what's with this "risk-free" bit?

Repaying a mortgage is without risk, as long as you've got the receipts. To be equivalent, then, you need an investment that carries no risk.

A term deposit in a major bank would more or less qualify. But could you get one that pays higher interest than mortgage rates?

Almost always, no. Banks have to charge more interest on loans than they pay on deposits, or they would never cover their costs, let alone make a profit.

So it's silly to have a mortgage and also have long-term savings in term deposits.

What about investments that bring in higher returns, such as shares, share funds or property? Their returns are volatile, which raises their risk.

You might find that, in our example above, one year you earned $800, the next minus $2000, the next $5000.

Could this happen with property? Certainly, if you include house price fluctuations.

Over the long term, the average return in shares or property would probably be above the $1000 available on a risk-free investment.

But that might take quite a few years. If you've invested poorly, it might never happen.

In the meantime, you won't enjoy watching the value of your investment sometimes fall, when the money could have been knocking back your mortgage.

Because of the volatility and risk of higher-return investments, many advisers say it's better to concentrate on repaying your mortgage first.

And to a considerable extent I agree, for financial but also "human" reasons.

Repaying your mortgage is simple.

And you gain the security of getting a mortgage-free home faster. There is, though, another side to the argument. You're better diversified if you invest beyond your home.

Also, you get into the investing habit. And, by starting to invest earlier, you can watch long-term market trends.

Those who have been in share funds for a few decades certainly find it easier to tolerate market dives, such as the current one, than newcomers.

In light of all that, I think it's a good idea to do a bit of both. Put the bulk of your savings against the mortgage. But put, say, $100 a month - money that you're happy to tie up for 10 years or more - into a share fund.

I wouldn't recommend another property. You wouldn't be diversified. Also, running rental properties from overseas can be troublesome.

Which brings me to the promised added consideration for rental property owners.

Unlike home owners, your interest payments are tax-deductible.

So when you're weighing up mortgage interest rates versus after-tax returns on investments, you need to consider what mortgage rate you're really paying, after taking tax into account.

If you're in the 19.5 per cent tax bracket (on an income less than $38,000), multiply the mortgage interest rate by 0.805. For example, a 7 per cent mortgage costs you about 5.6 per cent after tax.

If you're in the 33 per cent bracket (an income of $38,000 to $60,000), multiply the rate by 0.67. A 7 per cent mortgage would cost about 4.7 per cent after tax.

If you're in the 39 per cent bracket (an income of more than $60,000), multiply the rate by 0.61. A 7 per cent mortgage would cost about 4.3 per cent after tax.

This means that it's easier for you to find an investment that beats repaying your mortgage. So you might want to lean a bit more in the investment direction.

Q. My husband and I avidly read your column every week, as we have a share portfolio which we manage ourselves and some investments with ASB Easyplan and unit trusts which have performed dismally for the year we've been in them. But we know we have to grit it out for the long term.

Sometimes we find the answers in your column very hard to understand. I know there are some very knowledgeable people who read it, but we both found a recent column difficult to fathom.

Are you able to explain in more simple layman terms for the likes of us poor mortals?

A. Thanks for the feedback. When I'm writing responses to letters, it's always a toss-up between explaining every term and concept to those who know little, and skipping over some of the details so that I don't bore those who know more.

Sometimes it depends on what I've done recently.

For instance, if I've described index funds or dollar cost averaging in depth one week, I tend to use the term with little definition for the next few weeks.

Of course, not everyone reads Money Matters every week. But what's a poor columnist to do? Reward loyal readers by dragging them through repetitive stuff?

Still, I'll keep your comments in mind. Perhaps I should put some explanations in brackets, so those in the know can skip past them. Any other ideas?

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