Debt v Investment: Should you wait or invest today?

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My partner and I have some surplus income each month and we are interested in investing, but still have a mortgage. Should we repay our home loan before looking to invest?


Financial planner Ben Hancock writes:
Debt reduction is often seen as the first priority for many home owners – however it is not always the most beneficial use of your surplus monies. One important factor that must be considered includes the borrowing cost of the debt as compared to the expected after tax (or net) return for your other investment alternatives.


For example, it would be prudent to repay or offset private loans (ie. non-deductible or ‘bad’ debt) with an interest rate of 7% pa if the best alternative were to establish a term deposit with an equivalent rate. The interest on a term deposit is taxable income and will be reduced to approximately 4.8% for the average income earner.


On the other hand, if you were to invest into a portfolio of ‘blue-chip’ Australian shares you could benefit from dividends that are currently averaging just over 6% pa, plus the tax (franking) credits that could increase the pre-tax dividend yield (ie. income expressed as a percentage) to over 8.5% pa before tax. In addition, if you invest in quality companies you should expect that an increase in asset prices will occur over time, to provide capital gains over and above the dividend income and overcome any shortfall in income on an after-tax basis.


Of course, there are a variety of investment options available that should be examined when considering the best use of your available funds. In addition to Australian shares, the most popular options include investment property and managed funds.


Residential investment property is currently unlikely to entice investors from an income perspective, as pre-tax rental yields are typically below 3.5% pa after holding costs such as insurance, management fees and rates, etc. In addition – being at the wrong end of a property boom – the return to be gained from increasing asset prices is likely to be subdued for some time.


Managed funds offer a passive alternative to direct shares and property and have the scope to incorporate a much broader range of asset types, which reduce risk through diversification. It is common for managed fund portfolios to include assets such as bonds, property and shares, both within and outside Australia, in addition to less commonly held assets such as commodities (eg. gold and iron ore) and currency. The income from these types of assets varies considerably and should be projected by a person with suitable experience according to the composition of the particular assets held.

 

Repaying ‘bad’ debt is always going to be of benefit – but as to whether it should replace investment depends on the anticipated return on your best alternative options.


Where to find out more:
Answer this week was provided by Certified Financial Planner (CFP) Ben Hancock of Stonehouse Wealth Management, a member of the Financial Planning Association. To find a financial planner, call the FPA on 1300 626 393 or visit www.goodadvice.com.au

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