In the swirling world of personal finance, there’s a hot potato question bounces around many investors' minds. Should you pay off your mortgage or invest? Which one offers a better return on investment?

As with most financial decisions, personal context is key.

On one side is the sweet liberation of being debt-free, with the word 'mortgage' now in your rearview mirror. On the other side, there's the buzz and excitement of potentially gaining wealth through long-term investing . Still, the choice isn't as binary as it appears. What if there's a twist in the narrative—like tax obligations?

In this episode, we help you cut through the fog of uncertainty before deciding whether to pay off your mortgage or invest. We explore important considerations such as interest rates, tax on investments, mortgage stress, and debt recycling.

A word of caution though—what we discuss here is not a one-size-fits-all kind of deal. Much like your preference for Vegemite or Marmite, choosing to pay off your mortgage or invest is a decision that’s unique to you. We’re here only to encourage research and empower you to make your money moves for the life you want.

How much is your interest rate?

Have you ever found yourself in a situation where you've received a surprise windfall in your bank account? It could be tax return, a bonus, or even a thoughtful gift from a relative. Do you chip away at your mortgage? Or do you glide into your brokerage account to invest?

Your home loan interest rate could be the swing vote in this decision.

Why, you ask?

Well, the rule of thumb here is simple. A high interest rate might make you consider becoming debt-free faster. It can save you a hefty sum on interest payments over time.

However, a low interest rate might tilt the scales towards investing your money. This path offers the potential of earning a return higher than what you're doling out in mortgage interest.

But remember: while investing might offer higher returns in some instances, performance in the sharemarket isn't set in stone. Paying off your mortgage, on the other hand, is a one-way bet with the house odds in your favour.

We'll explore this further below.

Comparing the investing returns versus paying off your mortgage

Let’s revisit the question once again. Should you prioritise investing or paying off your mortgage?

To answer this, let’s examine the average return of both choices.

History tells us that the sharemarket has averaged a return of around 7% per year . This means that a $10,000 bonus could potentially bring you around $700 annually if you decide to invest it.

Now, compare that to your mortgage. Let's say it has an interest rate of 6.54% (or $654 on top of your $10,000 bonus). It’s almost as much as the stock market’s average return.

When comparing these two options side by side, they seem remarkably similar, don't they? A 6.54% guaranteed return versus a potential 7% return. The choice isn't straightforward.

In truth, you’re actually deciding between the lure of the unknown and the comfort of the familiar. It’s the safer, sure-shot return versus the slightly higher but riskier option.

The 7% return of the sharemarket? It's a ghost of performance past. Some years, you might be riding high on a 15% return. Other years, it could make your stomach drop with a dismal -20% plunge. The ups and downs will always be a natural part of investing in the sharemarket .

Unlike the unpredictability of the stock market, your mortgage interest is a known entity. Paying off your mortgage offers you a guaranteed return. It’s the more comforting certainty amidst all financial decisions you’re going to make.

So, what's it going to be? The guaranteed return and high savings of paying down your mortgage? Or the potentially higher, yet risky, return of investing in the sharemarket?

The choice between investing and paying off your mortgage isn't about right or wrong. You see, financial decisions are as personal as they can get. It's about understanding your comfort level with risk, your mortgage rate, and your long-term financial goals.

For some, the thrill of the stock market is an adventure they'd love to embark upon. For others, the guaranteed return of paying off a mortgage feels safe, predictable, and comfortable. Weigh your options and make a decision that feels right for you .

In the end, it's your journey, your rules.

Paying tax on dividend income and capital gains

Investing. A word that conjures images of a high net worth early retirement, of lush holidays in Switzerland or the Maldives. But does it also make you think about…taxes? Probably not, but it should.

To understand tax rules on investing, let’s play the Monopoly game.

Tax treatment of dividends

Much like the rent you collect in Monopoly, dividends from shares are considered income. Remember the joy of an opponent landing on your Park Place with a hotel? That's the feeling of getting dividends, but it's also taxable.

Yes, you read it right. Even your virtual Monopoly tax office is working overtime here. So, next time you receive a dividend, remember that a slice of it is reserved for the tax office.

Capital Gains Tax

This is the tax you pay when you've played the game well. You buy low, sell high, and make a profit on your shares.

Let's say you bought Mayfair early in the game and sold it when the prices soared. That's a capital gain. But that’s also another point where the taxman says: "Hold up, I need my share.”

However, much like the lucky draw of a chance card, there are capital gain tax discounts you might be eligible for. Yes, a little unexpected bonus amid the taxing affairs!

To find out more about Capital Gains Taxes and how they affect you, visit the Australian Tax Office .

The Tax Effect

Imagine if there was a rule that paying off your debt could give you a higher net worth, even more than taxable investment income. This is what we call the Tax Effect. It may sound counter-intuitive, but try grossing up the figures. It may turn out that clearing your debts is the more beneficial route.

Dealing with mortgage stress

Ever heard the term "mortgage stress"? The decision to pay off your mortgage or to invest is not purely mathematical. It also has an emotional component.

Picture yourself stuck in a sinking boat with a small bucket to bail out water. The sinking boat represents you struggling to make mortgage repayments. The small bucket is your current income. The water flooding in faster than you can remove it symbolises mortgage stress.

Add to that the rising interest rates recently, which could flood the boat even faster.

When mortgage repayments become a constant thorn in your side, it's time to take action. Like plugging the hole to stop the sinking, sometimes it's better to pay off your mortgage sooner. The reassurance of a home is the equivalent of finding land for refuge.

Paying fixed vs. variable rates

Think of a fixed interest rate as your safety net. It's your surefire option that promises a consistent performance. Your mortgage payments remain the same throughout the loan term.

But remember, some fixed-interest loans may have tight leashes on overpayments. This acts as a barrier for those itching to pay off extra.

Variable interest rates, on the other, offer an option that's flexible and adaptable. The main benefit? They usually allow extra repayments and come with offset or redraw facilities. These features can reduce your overall interest and potentially help you save money in the long haul.

On one side, the stability of fixed interest. On the other, the flexibility of variable interest. But what if we could achieve the balance – the best of both worlds?

Here enters the split mortgage – part variable, part fixed. It provides a harmonious blend of stability and flexibility. It's a strategy we personally use.

Before you get too excited about paying off your mortgage early, check your mortgage terms. There might be a clause lying in the fine print about prepayment penalties.

If your mortgage is expiring in three months, don't just sit around waiting for the clock to tick. Reach out to your broker or bank. Can you negotiate a lower interest rate? It never hurts to ask, and you might just save some precious dollars.

Do you have a predictable cash flow?

Ever wonder why some people choose a fixed rate for their mortgage payments? Well, it comes down to the predictability of their cash flow.

Imagine knowing what's going to happen in every episode of your financial life. That's what understanding your cash flow does. It helps you budget monthly, ensuring you're never taken aback by any payments.

Now, let’s say you have a large sum of money that's sitting in your offset account. Rather than letting it gather digital dust, why not put it to work? Paying off a chunk of your loan and refinancing could reduce your repayments. It can leave you with more cash flow to grow your investment portfolio.

Understanding debt recycling

"Debt recycling" — sounds complicated, right? In the realm of personal finance, it sounds as if we're being asked to juggle balls while riding a unicycle.

But here's the surprise: debt recycling is simply about making your existing debt work smarter for you.

In essence, debt recycling takes the equity in your home. It’s the difference between your home's value and your existing mortgage. The money with which you paid a portion of the mortgage can be re-borrowed to be invested in income-generating assets.

In other words, you end up with potentially minimised tax liability on your property because your money didn’t stay as a mortgage repayment. In fact, you took the money back out and turned it into a tax-deductible investment loan.

A bit like turning water into wine, right? But hang on, there’s more to it. As you lower your non tax-deductible debt (your mortgage), the potential for tax-deductible debt (the investment loan) gets bigger.

For example, if your house is worth $800,000, and you still owe $300,000 on your mortgage, your equity is $500,000 (non tax-deductible). This means you have $500,000 that you can re-borrow to invest in ETFs that pay dividends, for example. The income from the investment (tax-deductible) can then be used to pay down the rest of your mortgage (non tax-deductible).

What do you with the investment income? This is the part where it gets exciting!

You can use that investment income to pay down the rest of your mortgage. If you keep repeating this process, the mortgage will get smaller until you only have a tax-deductible investment loan left. From here, it’s up to you how you approach the repayment on the investment loan (hint: dividends!).

In short, it’s a way to turn bad debt (mortgage) into a good debt (income-generating investment).

Let's set things straight: debt recycling isn't a golden ticket to financial success. It isn't like throwing your debts in a recycling bin and watching them transform into wealth.

There's a lot of meticulous planning, shrewd understanding, risk tolerance, and responsible execution behind it. So, before diving in, consult your financial advisor and tax accountant.

Avoiding concentration risk

Do you remember the old axiom about not putting all your eggs in one basket? Imagine carrying a basket of freshly collected eggs from the chicken coop to your kitchen. If you trip and all your eggs are in that one basket, well, it's an uncooked omelette on the ground.

Now, consider your investment portfolio as that basket of eggs. The term “concentration risk” rings a bell, doesn't it?

Simply put, concentration risk is where you invest all your money into a single asset class, like shares or property.

Chances are, your property is likely your most substantial asset. But what if its market value drops significantly? That's a large chunk of your net worth vanishing overnight. It’s like that eggs on the ground scenario but on a grander, more heartbreaking scale.

However, here's the interesting part: long-term investing is not a merciless egg-smashing monster. There's a strategy to counteract this risk. A saving grace, known as “diversification”.

In layperson's terms, diversification means spreading your investments across various asset classes . Some examples of asset classes are shares, bonds, cash, and property. If one basket tips over, the rest of your eggs are safe and sound.

Of course, keeping track of all these metaphorical egg baskets sounds overwhelming. We've got you covered in our 13th episode , where we talk about how to track your investment portfolio , and what to track in it.

Do you have other sources of income?

Making money isn't confined to your day job. Ever heard of dividends? They're like a company's way of saying 'thank you' for investing in them.

When you invest in a company that consistently pays dividends, it's akin to having a golden goose. But remember, while the goose lays golden eggs, they are not immune to the ups and downs of the market. The value of these eggs – the dividends – can fluctuate. So, while it’s thrilling to find new streams of income, always bear in mind the associated risks.

So, should you rush to pay off your mortgage or direct that money into investments?

If your dividend income is stable and reliable, it might be more logical to invest that cash rather than clear your mortgage debt.

However, here’s a plot twist. Dividend income isn't immune to taxation. This means the government will want a piece of your pie too. While this might feel like a dampener, it's crucial to consider this fact before making your financial moves.

What’s your risk tolerance?

Consider this: do the mere words 'stock market' give you cold sweats, or do they make your pulse race with excitement? This gut reaction could be a telling sign of your risk tolerance.

Imagine you're at a pool party. Two friends invite you to join them. One is enjoying a calm swim in the shallow end (let's call her 'Mortgage Maggie'); the other is preparing to jump off the diving board (we'll name her 'Investing Isabelle').

Mortgage Maggie is content. She's worked hard to pay off her mortgage and now enjoys the freedom of being debt-free. She's not swimming in wealth, but she's secure and comfortable.

Investing Isabelle, however, is eyeing the potential of the deep end. She’s comfortable with the risks and sees the opportunity for higher returns. Yet, she acknowledges the possibility of losing some, or even all, of her investment.

Which pool party guest do you identify with more?

Think about your financial goals and the opportunity costs

We often find ourselves at a crossroads. One path leads towards shares and the other towards your offset account. Both roads look promising, but which one should you walk?

The answer? Well, it's not as complicated as it seems, and it mostly depends on what you're saving for.

Let's say you're saving up for a short-term goal like paying off your mortgage. Then, it might make more sense to put that extra money into your offset account.

Why? Because investing in shares is generally a long-term game. You'll need a bit of patience as sharemarkets go through different seasons of gain and loss. You can never predict when will be the next season to reap the profits.

But, if you're not in a rush to use the money, then shares might be your ticket to a more profitable future. Sure, it takes time and patience, and you'll assume some risk, but the reward can be worth the wait.

Then there's the tricky concept of opportunity cost when you choose to invest. Opportunity cost could be the potential earnings you may have missed out on if you'd chosen a different investment.

Do you feel like you might make more money on the stock market? And is this a potential opportunity you're missing out on? Or do you believe you'll be better off reducing your mortgage for more stability and cash flow?

In the grand scheme of things, it's not just about the numbers. It's also about your goals, your risk tolerance, and your perception of what you might be leaving behind.

Take action this week

You may be grappling with the decision on whether to pay off your mortgage or invest your hard-earned money. There simply isn't a pre-set playbook everyone can run by. The ultimate choice should echo your circumstances, financial goals, and life’s unexpected detours.

Still can't decide between investing or paying off your mortgage? The beauty of this episode is you can put it into practice starting with few, simple steps.

Just like you'd double-check a recipe before cooking, ensure you know your interest rates like the back of your hand. If it's fixed, put a reminder on your calendar for when the rate changes, and compute your new repayments. The more prepared you are, the less you'll feel like a deer caught in the headlights.

As you decide whether to invest or pay off your mortgage, remember that each option has its unique benefits and drawbacks. Tipping the scales in favour of one depends largely on your personal financial goals and the risk you're willing to embrace.

If you're still in two minds, then don't hesitate to plug into our full episode for a deeper dive into this exciting topic. Whichever path you choose, remember: it's about the life you're building and the person you aspire to be.

Happy investing!

Tash & Ana