Updated: Dec 6, 2019
Should I pay off my home loan or contribute more to superannuation? Mathematically the decision is quite simple, contribute pre-tax to super. However, the decision is complicated by an individual's personal circumstances and the assumptions that are made, thus the answer is not all that simple after all. I will break this down to it's lowest denominator.
So let’s explain the mathematics part first.
This is all about the marginal tax rate, or put another way the tax rate on the last of the dollars that you earn. For every taxable dollar that you earn over $37000 you pay 32.5% in tax, over $90000 it is 37% and over $180000 it’s 45% (and that excludes medicare levies). Where as, when you contribute to superannuation before tax, referred to as concessional contributions, your tax liability is only pay 15% tax.
So let’s assume we have a taxable income somewhere between $46,000 and $90,000 per annum and that we can save $100per week after tax, which equals $5,200 per annum. We will thus have a marginal tax rate of 37% plus 2% medicare levies, that’s 39% that you are going to pay the tax man. .
We can either pay our home loan down by $5,200 or due to the tax savings contribute $7,245 (after super contribution tax) to our super. This is a $2,045 tax benefit for contributing to our super before tax (concessionally). Thus over ten years we will contribute an additional $20,450.*
Tax implication calculations contributing to super:
Amount to Super: $5,200 / (1- 34.5%) x (1-15%) = $6,748
Contribute to Super vs Home Loan: $7,245 - $5200 = $1,548
Tax benefit over 10 years: $1,548 x 10 = $15,480
Again we need to make assumptions. Let's assume an average 4.5% interest rate on your home loan and assume that our superannuation fund averages a 7% return after tax, fees and charges . We will also assume that we have put the $100 per week or $5,200 p.a. for 10 years to our chosen strategy.
Contributing to our home loan we would save $11,583 in interest payments but if we contribute to super instead we would earn $23,382 on our super investment. Thus there is a further net earning benefit of $11,799.*
Total improved benefit $27,279*
This benefit will only improve as you start earning over $90,000 p.a.
Once retired, you can then take a lump sum out of your super and pay off your home loan with the increased amount accumulated within your super.
So that’s simple but what’s the catch?
This is where your personal circumstances and other considerations need to be taken into account to determine whether contributing to your home loan or to your superannuation is the best decision for you. The five points below should cover the main considerations but other variables may also need to be considered.
1) Safety Net
Amounts contributed to super are largely inaccessible until retirement. You need to consider your safety net in the event that you are unable to work, lose your job or incur an unexpected large expense. It is important that you are able to sleep at night thus you need to consider the size of your financial buffer from which the additional contributions to super may detract.
2) Superannuation laws may change
Superannuation laws have the potential to change.
3) The assumptions used may vary
Your superannuation may make lower (or higher returns) than what we projected. If there is a large drop to the share market and subsequently your super fund balance you may lose the potential benefit, and even more. Your super may also move in a more positive direction.
The interest rate on your home loan may change.
With a change in employment your marginal tax rate may change. Note that you can stop making additional contributions at any stage.
4) Equity Growth
Paying down your home loan will increase your equity position which may enable you to purchase property or refinance loans more easily. This may be particularly relevant if your loans go from interest only payments to principle and interest and your cash flow ends up in a tight spot.
5) Miscellaneous other factors
Your age and the time period you will need to wait before being able to access your superannuation.
Your loan balance,
Is the loan fixed,
Can you make additional contributions
Concessionary contributions are capped at $25,000 per year, and this number includes the compulsory contribution made by your employer.
* Calculations for those that like to see how the benefits have been calculated
Table 1: Benefits gained paying down home loan
Table 2: Benefit gained contributing to superannuation
Table 3: Net Benefit (table 2 less table 3)
Additional Contributions = Total to Super (Table 2) - Additional to Home Loan (Table 1)
Additional Earnings = Total Earnings (Table 2) - Total Interest Saved (Table 1)
Disclaimer: Please note that the calculations are only valid for the set of assumptions detailed above. Differing contribution amounts, marginal tax rates, superannuation returns, interest rates and time periods will deliver a different result. I am not a licensed financial adviser and this is general information only, so it is up to you to seek professional advice before acting.
Further information and calculators are available on the ASIC's MoneySmart website