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Hudson Financial Planning - Debt reduction or investment

Debt Reduction Or Investment?

Years of historically low interest rates and anticipated appreciating share and property markets presents the perfect opportunity to rehash the following ‘after tax return’ formula to determine what to do with surplus cashflow.  Please note: this only takes into account the financial perspective – it does not look at other psychological factors that impact investing.

When looking at an investment return, you must always factor in tax.  This is particularly true when evaluating whether you should use funds to invest OR use funds for debt reduction.

When you repay debt, you in effect earn a return equal to the interest rate on that debt – tax free.  So you need to know the potential after tax return of the alternative to make an informed choice.

This is the magic formula:

After tax return = return x (1-tax rate)

Let’s assume an investment has returned 7% after fees and is held by someone whose income falls below $90,000 and pays tax at 34.5% (including the Medicare levy) and has mortgage interest rates of 3.00%.  So the calculation is:

After tax return = 7% x (1-0.345)

The result is 4.59%.

In other words, on an after tax basis you would be earning more than current mortgage interest rates.

Looking at it a different way, you would need a pretax return of 4.58% to beat paying down the mortgage.

[3.00%/(1-0.345)] = 4.58% pretax return required.

Looking at another example, if we take an individual with a higher tax rate of 39.00% inclusive of the Medicare Levy and mortgage rates of 2.50% the result is:

[2.50%/(1-0.39)] = 4.10% pretax tax return required

With ANZ bank economists forecasting 9% gains across Australian capital cities in 2021, and general optimism regarding the continued appreciation of sharemarkets,  it’s time to consider rethinking paying down debt in the current climate.

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