Debt vs Investment

Question

Hello Phillip,

I have $100.000.00 mortgage and about $40.000 in a savings and protection plan with Sovereign and have received $20.000 in cash.

I have no hire purchases or large credit card debts and are in my late forties and would like some advice.

The savings plan returns very little and I have cut my contributions right back to allow money for the mortgage.

Over the years I have argued with the broker that people say pay off the debts first but they say no you will reap a good reward over time and yes there has been the odd good year but I am not happy this money is in the right place.

What do you think?

Answer

Fundamentally you are right, debt free is the ultimate target of us all - any debt equates to an increase in risk. However there are several points of argument.

I assume the mortgage is on your own private home therefore is not exposed to any taxation benefits, by this I mean that you are unable to deduct the interest paid as incurred in pursuit of investment. If this is the case and you are earning an average to good salary you will be paying tax at around 24 - 26% on each dollar of interest paid. Or put another way each dollar of interest you pay requires you to earn $1.30 gross.

The $40,000 in savings also is not very effective if it is not earning more than the pretax equivalent of the mortgage cost. For example why have that sum invested at say 7.25% gross of tax (5.51% after tax) when the mortgage interest is 8.25% or say 10.73% per annum pretax equivalent.

Some year’s back folk thought up a wonderful way to sell more of these investments – they convinced folk that a mortgage could be repaid by investing into a fund that was going to grow at a rate much quicker than the mortgage interest. Pity they forgot to tell the same folk about taxation and market cycles and performance volatility.

The Sovereign plan is not a smart option if the fund supporting that investment component is taxed at 33.00% - regardless of the investment return being average or poor as you suggest and it seems that the funds selected are not suitable to your risk profile.

My view is that investment and insurance in one plan are not usually good bed fellows. The expenses/fees tend to merge, the insurance component is not easily dealt with or assigned if required and the investment performance is regularly not what is expected by the client. Be aware that the broker will be collecting a handsome ongoing annual fee while you keep the contract so has an interest in you staying with the game.

I suggest you take the Sovereign plan and separate the insurance and investment, If you require insurance fine, arrange that in a standalone plan. Take the investment funds along with the savings and repay the mortgage. From an investment perspective you are then able to consider whether you are going to concentrate on reducing the balance ($40,000) of the mortgage or take the option of more tax effective borrowings and investment options which will see you much better off short and long term.

Original Article published August 2006