One of the greatest money quandaries for those who own a house is whether extra funds should go towards the mortgage or invest.
I even wrote an article about this myself.
Whenever I bring up this topic, the payoff the mortgage camp are extremely staunch and it seems that the majority of New Zealander’s are in this camp, which has prompted several of my articles about the fact that you can’t eat your house in retirement.
But one of the most common arguments I hear, which I’d like to discuss today, goes something like this:
“Extra mortgage payments are tax free, whereas I am taxed 30% on my investment gains. This makes paying off the mortgage a no brainer”
This statement is wrong. For several reasons.
Why this pay off the mortgage argument is wrong
I’m not saying paying off the mortgage quickly is wrong. Not at all. I am just saying that this particular argument is wrong.
1/. Total investment returns are not taxed. Only dividend returns
Let’s say the mortgage rate is 4% and the investment returns are 6% after fees. The pay off mortgage camp will say that the 6% investment returns become 4% after tax thanks to a personal income tax rate of 30 or 33%.
So of course it makes sense to pay off the mortgage if both rates are the same, right? The mortgage return is guaranteed. The investment returns are far from guaranteed.
The problem with this is that the return assumptions of the investments are incorrect. Yes, your tax rate may be 30 or 33%. But not all of your investment gains are taxed. In fact, probably not even half of your gains are taxed if you are widely diversified.
First of all, share returns are made up of two factors. Capital gains and dividends received. It depends on what companies you invest in, but it is quite common over the long term for dividends to make up only 50% of someone’s total returns. Much less over shorter time periods due to less compounding.
So, if your total return is 6%, then your dividend returns may only be about 3%, if not less. So claiming a 33% tax rate on 6% is wrong, since the 3% of capital gains is not taxed. Only 33% of 3% dividend returns is taxed, which is just 1%, not 2%.
This makes the investment returns in the argument 5%, not 4%. And we all should know the difference 1% makes over the long term.
4% vs 5% returns on $10K contributions per year
But is the extra risk of unknown returns of shares worth the higher potential return? Only you can answer that. But at least go in using the correct number assumptions.
2/. No capital gains tax in New Zealand
Further to the first point, in New Zealand investors don’t pay any tax on the capital gains of the shares that we purchase from New Zealand based fund managers. The only tax we pay is on dividends.
3/. Imputed tax credits benefit
In addition to no capital gains tax, New Zealand funds tend to have most of the dividend tax covered by the companies we invest in, meaning we only have to pay a maximum of 5% of tax.
Many New Zealand companies pay up to 28% tax on the dividends you receive in what is known as imputation credits. These credits get passed on to you, the investor. So, you only need to pay the difference between your tax rate and 28%. If your tax rate is less than 28% then you may even receive a refund.
As most of us who invest do have home bias, we are invested in New Zealand companies. As a result, we may only be taxed on 5% of our New Zealand company returns. Let’s say that NZ shares make up 25% of your portfolio. One quarter of your 3% returns will only be taxed at a maximum of 5%.
This equates to a 0.15% deduction from your pre- tax returns. In other words, 6% becomes 5.85%.
So this leaves only three quarters of your international portfolio returns (assuming same returns for NZ as worldwide) incurring the 33% of tax on 3% of taxable returns with the given assumptions.
Summary
Let’s say you have $20,000 invested and made 6% or $1,200 in investment returns (after fees) this year. $300 (25% of returns) from New Zealand shares, and $900 (75% of returns) from international shares.
We will assume a generous half of the total returns were from dividends:
NZ - $150
International - $450
We will assume the NZ companies were taxed at 5% thanks to imputation credits, and the international company shares were taxed at our personal tax rate. 33% in this example. Tax paid:
NZ – $7.50
International - $148.50
Total tax paid = $156
$1200 in returns - $156 tax = $1,044 in the metaphorical hand.
$1,044/$20,000 invested = 5.22% returns.
This is a far cry from the 4% returns that many people assume when making the comparison.
And if your tax rate is lower, or your proportion of dividends to total returns is less than 50%, then the returns in your pocket will be even higher than 5.22%.
I am not saying share returns will be 6% and mortgage returns will be 4%. This is just an example. However, I do expect share returns to exceed mortgage interest rates over the long term due to the extra risk. Whether they will or not is to be determined. No one can say for sure. And this is why many people favour the pay off mortgage. For the certainty of returns.
There are many other arguments to paying off the mortgage or investing debate which we won’t get in to today. You can read my guest article I linked to in the introduction for more on that.
I just wanted to clarify what I considered to be an often-misunderstood argument. It may not be as cut and dry as you think.
As always, thanks for reading. Especially with so many numbers in today’s post!
If you need a personalised plan that makes the most of your housing asset whilst ensuring your individual goals are considered, then get in touch and we may be able to help.
The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here