Borrowing to invest in quality assets has always been one of the key ways to speed up the journey to wealth. However, there is almost certainly going to come a time in your life when you want to be free of debt, and this presents the obvious challenge of what strategy you should adopt to pay off your loans.
One straightforward strategy is to use a principal and interest (P&I) loan, and structure your payments so the loan will be paid off at the end of the loan term.
However, a much better strategy for many people is to create a sinking fund. Superannuation can be a powerful tool when used for this purpose. But first, let's recap the difference between pre-tax and after-tax dollars, because if you don't understand that, you won't appreciate why this strategy is so powerful.
Items of a personal nature, such as holidays or interest on your home loan, are paid with after-tax dollars; you can't claim a tax deduction for them. Therefore, if you are a high-income earner, you have to earn $189 in gross salary to spend $100 net. So a bill for $1000 for rates on your home could cost you $1,890 in pre-tax dollars.
But deductible items, such as interest and rates on your investment properties, are paid from pre-tax dollars. A bill for $1000 for rates on your investment property really does cost you $1000. This is why you should always prioritise paying back non-deductible home loans over deductible investment loans.
CASE STUDY: John and Julie are both aged 55, and they have a $200,000 investment loan at 4.5 per cent on an interest-only (IO) basis. Their goal is to have it paid off by their retirement, in 10 years' time. They have been considering converting it to a 10-year P&I loan, on which the payments would be $2073 a month. They are both in the upper-middle tax bracket, which means the cost of a $2073 monthly payment on their P&I loan would be $3400 in pre-tax dollars.
An alternative would be to stick with the IO loan, which costs them only $750 a month in pre-tax dollars, and salary sacrifice $2650 a month into superannuation. Contributions tax would take 15 per cent (or $397) but they would still be making a net contribution of $2253 a month. If their super fund achieved 8 per cent a year, they would have $392,000 in 10 years. They could then withdraw $200,000 tax-free to pay off the loan and still have $192,000 extra in their super.
The P&I strategy just pays their loan off, but the combination of an IO loan and salary sacrifice into a superannuation sinking fund both pays their loan paid off and gives them an extra $192,000 for the same initial cost.
A better strategy again may be to leave the super intact and, from the age of 65, simply withdraw $9000 tax-free each year to pay the interest. After a further five years of 8 per cent returns, the super may be worth $520,000, even after the withdrawals of $9000 a year have been taken into account. Remember, there is now no limit on what you can accumulate in super, and all withdrawals are tax-free after age 60.
John and Julie would need to take into account that deductible contributions, including the employer contribution, are limited to $25,000 a year each. Therefore, they would both need to make sure their individual contributions did not take them over $25,000 a year when the employer contribution is taken into account.
Obviously, there are many factors to consider before using the above strategies. These include the age at which you intend to retire, and lack of access to super until preservation age. However, in many cases, creating a sinking fund in superannuation is going to be the most effective strategy to pay off debts and retire in comfort.
- Noel Whittaker is the author of Making Money Made Simple and other books on personal finance. noel@noelwhittaker.com.au
