What is the priority: repaying your home loan or investing?

My goal is to give you simple , easy to understand strategies , insights and tips to help you master the game of building wealth , and in this episode , I'd like to talk about whether repaying your home loan is a priority or , in fact , whether you'd be better off directing some of your surplus cash flow towards investing .

Many people can be really focused on repaying their home loan in full before they begin investing . They can be so adverse to debt that they can't envisage them actually investing before their home loan is down to zero .

However , this isn't always the best approach and at some point , debt reduction starts to become less important than building investment assets , and that's what I'd like to address in this podcast . What are some of the considerations that you need to take into account when deciding which is more important for you debt reduction or investing in other assets ?

In fact , there's three questions that I think you need to go and ask yourself to really arrive at that conclusion . The first one is to ask yourself whether you have sufficient financial buffers in place Now .

Financial buffer will allow you to continue to pay for living expenses and financial commitments if your circumstances change , such as a loss of income , changes in expenses , those sorts of things .

Now , a financial buffer can consist of access to redraw , so that is , if you've made extra repayments into a loan that you can access , as in withdraw from the loan in the future if you need to , and or cash in offset accounts . Offset accounts can be a great way to store those cash savings for a rainy day .

How much buffer you need really depends on your own individual circumstances . But things like how secure and predictable your income is and the extent of your financial commitments can determine how much buffer is prudent .

So , for example , if your income is relatively unpredictable , so you have a lot of at-risk income , you're paid on a commission basis , you're self-employed and business can be variable those sorts of things then I typically would prefer a client to have one to two years worth of living expenses and commitments as a buffer .

Similarly , if you have substantial commitments , so that is , a high gearing to asset or high gearing to income ratio then it's prudent also to hold larger buffers , again , maybe one to two years worth of living expenses .

Otherwise , for people that don't sort of fall into those kind of two categories , a buffer of somewhere between six to twelve months of living expenses and commitments should be enough , but it really does depend on your kind of sleep at night factor .

Some people are going to feel more comfortable the more they have , and that's something you just really need to ask yourself . But before you consider investing , it's really important to ensure that you do have sufficient buffers in place , and if you don't , that's got to be your number one goal .

The next question you need to ask yourself is will you be able to reduce debts sufficiently before you retire ? So if you continue on your trajectory in terms of how much cash flow you're contributing in towards debt reduction , are you on the right track ? And so there's two things that you need to think about here .

The first one is that typically , you want to repay all non-tax deductible debts so all home loan debt , maybe a couple of years before you retire . It's not necessary that you've got to repay that debt as soon as absolutely possible .

In fact , doing so , as I said , might mean that you miss opportunities in terms of building wealth in other assets , but you certainly want to have that debt gone or fully repaid by the time you retire . The second consideration is that you want to reduce investment debt . So if you've got investment properties and associated debt with those properties .

You don't necessarily want to reduce that debt to zero . Having some level of investment debt , even in retirement , is really efficient use of capital and equity and so forth .

What you don't want to do , though , is , by the time you get to retirement , you don't want to have a lot of sensitivity to interest rate changes or increases and so forth , and also , you don't want your investment property portfolio to be costing you any money , necessarily need it to be generating a lot of income for you .

You just don't want it to be taking money out of your pocket in retirement , because if it's taking money out of your pocket , if it's negative cash flow , it means you're going to have to be more aggressive in dipping into other assets , such as superannuation .

So , really , the main goal or aim is to reduce your investment debt by the time you get to retirement to an extent where the property portfolio is neutral , maybe even slightly negative . Cash flow like a small negative cash flow is not going to worry anyone . Neither is a small positive cash flow . You just want it sort of around that neutral level .

So , therefore , you've got to work out how much of your annual surplus cash flow do you need to direct towards debt reduction , firstly your home loan and then secondly , potentially investment debt , to try and achieve those two outcomes , and if you're well on track to doing that that is , you don't need to necessarily continue to direct so much cash flow towards

debt reduction Then clearly there might be an opportunity if you start redirecting some of that cash flow towards building or investing in other growth assets . The third and final question , and somewhat interrelated to that second question , is how sensitive is your cash flow to interest rate changes ?

So if you have borrowed a substantial amount of money , particularly compared to your income , in that situation the most important thing is to actually reduce your sensitivity to interest rates , because you want to get to a situation where it doesn't really matter what the interest rate is .

You can still afford to maintain your current standard of living , and so if you've recently upgraded a home or purchased a home , for instance , you might have pushed the envelope in terms of borrowing capacity , and that's fine .

But the next step then is to really aggressively reduce debt , to bring it back into more comfortable or safe levels , and a rule of thumb and rule of thumbs aren't perfect but it gives you a good sense of what do I consider to be sensitive to interest rates ?

Really , the rule of thumb is if your loan repayments are 25% or more of your total gross income your gross salary income it's probably likely that you should really be focusing on debt reduction and reducing it below that sort of 25% benchmark . Again , it's just a rule of thumb .

The best thing is to really look at your actual cash flow and see how sensitive you are to interest rates . But that would be the third and final consideration . So therefore , to summarize , if you have sufficient buffers in place , you're on track to reduce debt enough by the time you get to retire .

So repay your home loan in full and reduce any negative cash flow on an investment property portfolio . And third , if , as long as you're not sensitive to interest rate increases , then it's likely that you would actually be better off directing some of your surplus cash flow towards investing in more growth assets rather than debt reduction .

So sometimes we meet clients that have spent or wasted a little bit of time or too much time repaying their debt . So , for example , maybe their debt was their home loan . Debt was $350,000 five years ago , when they've spent the last five years paying that down to zero To a large extent . We think this is a bit of a waste of time or a missed opportunity .

In many cases , it's likely they would have been much better off actually to take much longer to repay that home loan maybe another 10 or even 15 years and instead invest in growth assets . So , for example , over the last five years the International share index has returned 11.5% . Well , interest rates haven't been anywhere near 11.5% over the last five years .

So in that situation that person would have been much better off directing at least some of their cash flow towards debt reduction . So there is going to be a point where repaying incremental amounts off the home loan isn't really going to provide enough reward in terms of financial reward .

And really the most important comparison is what will be your long term average interest rate on your home loan , and I would say it's going to be somewhere between 5% to 7% would be a rational , reasonable kind of range , long term range . Let's pick the midpoint , 6% . Then the next question is what can you earn investing in growth assets on an after tax basis ?

And as long as that answer is more than 6% , which it should be , then you're probably better off , or you're going to be better off , investing in growth assets as opposed to reducing debt , as long as , as I said , you can answer yes to those three questions that I just discussed . So what do you do if you're in the situation where cash flow isn't enough ?

That is , that you work out that even if you put 100% of your surplus cash flow towards debt reduction , it's still not going to get you there , in that it's either not going to help you repay all your non-tax deductible debt or you're still going to be left with too much investment debt by the time you retire .

Well , clearly you need to have a strategy around how you're going to deal with this , and it's better that you come up with that strategy today than wait another 10 or 15 years until you're in that situation and then sort of look back and think well , I should have done things differently , of course .

So let me share a couple of ideas of what you could consider as sort of alternative debt repayment strategies . The first one is you can sell investments .

Obviously , selling investments will help you reduce debt , firstly because , if they have debt attached to them , it will reduce your overall debt , and then , secondly , if you're able to crystallise equity or walk away with some cash sale proceeds from those sales , then you can put those cash sales proceeds towards debt reduction as well .

Now , while asset sales might be a good way to reduce your overall debt , it's not really the reason why we buy these assets . I mean , it could be , but mostly the reason why we buy these assets is to build wealth and really to hang on to these assets for as long as possible to really enjoy the benefits of compounding capital growth .

So I've got a link to a chart on the blog on the website , that shows that the power of compounding capital growth really kicks in after owning an asset for 20 or more years . So the dollar value return in the years 20 to 30 is more than double the dollar value return in the first 20 years . So you really do get that compounding capital growth .

So in that situation , I'm really loath to sell assets because I feel like , well , there's a massive opportunity cost associated with doing that . Now , if you've got to do it , if that's the only way that your strategy is going to work , then great .

But really my goal when working with clients is trying to build a strategy that doesn't require asset sales , just because the whole point of hanging on to those assets is that we've done all the hard work . In owning or holding an asset .

For the first 10 or 20 years , you get decent returns , but the returns after 20 years is really where most of the dollar value returns going to come and that's really where we're going to start building substantial wealth . The second option is to withdraw from super .

So you might be able to withdraw money from super , obviously , reduce your debt or even service debt . Again , I typically like to avoid doing that because what you're doing is taking money out of a very tax effective environment In a period of time . We actually want to preserve the money in super in retirement rather than take it out .

Every person can have up to $1.9 million invested in super after you're 60 and retired . That attracts zero tax rate Zero tax rate on the pension income that you take out , zero tax rate on any investment earnings also . So really the goal in retirement should be to preserve the balance in super rather than reduce it . So again , it works , but not perfect .

Another idea is to downsize your home . So if you've accumulated a lot of equity in your home , you might be able to downsize , reduce debt , pull out some cash flow and then buy a replacement asset . Now the one caution I have with this strategy is that sometimes , if you downsize accommodation size , it's not a proportionate downsize in terms of value .

So , for example , a client might sell a family home at a blue chip suburb for $3 million and then have to spend $2.5 million to go and buy a relatively new townhouse that gives them the amenity and the accommodation that they're looking for in still a really good quality area .

Maybe they often want to stay in the same suburb and so forth , but even though they might have half the size around that in terms of accommodation size , it doesn't still cost them quite a lot of money .

So this strategy around downsizing doesn't always work from a financial perspective , in terms of pulling out the cash , and you just need to really think carefully about what that's going to look like for you . If you're downsizing to a much cheaper location , well then , of course that's going to work , but that's something you're going to need to make friends with .

Now my final comment is that you always should have a plan B . So when I put a strategy together , I'm always thinking about how we're going to reduce debt to the level that , as I just spoke about , the appropriate level , and cash flow tends to be the primary way of doing that .

But I'm always trying to think about , you know , sort of plan for the worst , hope for the best . So I'm always trying to think about , if your cash flow doesn't turn out how we hope it will , how else can we repay debt ? And I want to have a couple of different strategies .

So , if I need to , I can sell assets or I can pull a little bit of money out of super . I typically don't want to build in a downsizing strategy unless it's absolutely necessary . So therefore , if you don't have a plan B , then maybe you need to put a plan B in place .

So , for example , if I've got a client and we think that cash flow is going to be enough to repay debt and they've got enough super but no other assets , in that situation I might actually recommend let's go and buy an investment property , because that will be our plan B .

We can fall back on the equity the investment property is going to generate to either repay debt or supplement super if either of those two things don't turn out as well as we hope . So really thinking about making sure you've got something some other asset pulled or fall back on is a good idea . Okay .

So just to summarize the three things you need to think about have a sufficient buffer in place . Make sure you're on track to reduce debt by a sufficient level by the time you get to retirement . Make sure that you're not sensitive to interest rate increases .

And once you can tick off those three things , then it's very likely that it's a good sign that you should be investing in other growth assets as soon as possible and don't let your emotional aversion to debt prevent you from making the most of your financial opportunities . Okay , that's it from me for this week , until next week . Bye for now .