Pay off the mortgage, or save?
By Richard Flinn
“Pay off the mortgage before you start saving.” If you look at some sources of information that offer advice on saving effectively, you may find this is their advice. However, it is not always this simple.
The key argument for this advice is based around comparing returns. Assume a mortgage rate of 9% and a current interest rate of, say, 6%. You have an economic choice as to where to place your next saved dollar. You could put it towards paying off your mortgage, or you could invest it for a return of 6%.
In this example, you are better off to reduce your mortgage. In fact, the only way that it makes better economic sense to save rather than reduce your mortgage, is if the return on your savings is higher than your current mortgage rate. Remember, you have to pay tax on any interest you earn on your savings. In our example, if your marginal tax rate were 33%, your investments would need to be earning more than 13.5% before tax, which is a very high return, to justify saving rather than paying off the mortgage.
So, in almost all cases, you are better off to pay down the mortgage before you start saving. But is it always that simple?
Pay off the mortgage or save?
Not all of us are completely and consistently rational when it comes to money. After all, people do buy on impulse. The phrase “retail therapy” has long been part of our modern vocabulary. The old proverb warns against being “penny wise and pound foolish”.
So, the way we deploy money can sometimes be anything but rational. This is something peculiar to that modern New Zealand idol – the residential home. This, for some New Zealanders, is a showcase and reflection of our success, lifestyle, and prosperity.
So, for that reason, some people may choose to tirelessly pay down the mortgage and put off starting a serious and consistent savings programme in the meantime. Such people can be comforted by the thought that it makes economic sense to do this and inwardly agree because their homes are a symbol of their wealth and financial success. In other words, there can be a lot of emotional capital held in people’s homes and this can come to the forefront when looking for an economic rationale.
However, and here is the catch, as the mortgage gets paid down, and the debt burden lightens, rather than beginning to think about saving, some New Zealanders begin to contemplate the next item of financial success instead. Certain economic rationale would suggest that this is the time to commence a long-term retirement savings programme. But the reality can also be that rather than starting a savings programme, the current house is sold and a bigger house is purchased, with a new (larger) mortgage. Such a course of action is seen as the next stage of success – not a long-term savings programme!
The upshot is that for some a savings programme is never started. Instead, those New Zealanders might move to a progressively bigger house and mortgage. And at each point (from a short term view) it makes better economic sense to reduce the current mortgage and delay starting to save for retirement.
However, the key is that there is a capitulation point in this treadmill. The time comes when that person tells him/herself that the family home is their retirement savings programme. However, this poses some questions – will you really want to downsize your home and status in retirement? And how much interest will you have paid the bank in a lifetime cycle of never-ending mortgage repayments?
Rather than arguing that it makes economic sense to pay off the mortgage before starting a long-term savings programme, it may be better to commit to a savings programme before the seduction of the ever-more-grand-residential home and ever-increasing mortgage bites deeply. Starting a savings habit early, means you’ll have more options in retirement. You may be able keep the house and have the lifestyle that you desire!
The views or information given in this article are not necessarily the views of AMP or AMP Adviser Businesses. It provides general financial information and is not intended to provide financial advice. For personalised financial advice, we recommend you contact us.