Should I pay down mortgage or save spare funds?

Many of us often put our spare funds into an offset or redraw with our mortgage to help reduce the interest paid so more goes towards the principle. However, with recent interest rate rises, high interest savings accounts (HISA) and term deposits are offering much higher interest rates than they have for the past few years, making it a competitive alternative.  

So, is it better to save interest by keeping it in a 100% offset or redraw facility or earn interest in a HISA or term deposit? Let’s take a closer look.

If you’re one of the savvy people that fixed your home loan when interest rates were rock-bottom, and still have another year or two left on your loan, it may be that you could earn more interest with your spare funds than you could save interest by putting them in an offset or redraw.  

If you had $10,000 in your redraw or offset at a fixed-rate loan of 2.00%, this only saves you $200 in interest from your mortgage. If you put it into a HISA or term deposit at 4.00%, that earns you $400 a year. Interest earned however, is subject to income tax, which means that $400 will see a chunk taken out depending on your marginal tax rate.

If you have a higher variable or fixed rate mortgage, then you will almost certainly save more in interest (i.e. putting your spare funds into an offset or redraw) than you would earn from a HISA or term deposit when you take into account income tax. 

While offset and redraw facilities have no tax implications, HISA and term deposits do. Interest earned (from savings) is seen as taxable income, while interest saved (from paying down a loan) is not.  

You’ll need to weigh up which is greater: interest saved by paying down your mortgage, or interest earned from a HISA or term deposit minus tax. Fortunately, there’s a formula you can use to work this out.  

In a recent newsletter, Savings.com.au recommended using the below formula to work out what your break-even interest rate would be inclusive of tax:  

• Mortgage rate ÷ (1 - marginal tax rate expressed as decimal)  

• For example: 1.99% ÷ (1 - 0.325) = 2.94% p.a.  

In the example above, the individual has a fixed mortgage rate at 1.99% and a marginal tax rate of 32.5%. They would need to earn 2.94% p.a. or more on a HISA or term deposit in order to break even.  

If your fixed mortgage rate is a little higher, for example 3.00%, then the interest rate you’d need to break even would be higher: 3.00% ÷ (1 - 0.325) = 4.44% p.a. to break even.

While the formula may seem simple, it can be more complex in reality.  

You may need to take into account other factors such as negative gearing tax benefits, the amount still remaining on your mortgage, if your mortgage rate is fixed or variable (or both), how long your fixed mortgage rate has left (if applicable), the amount of spare funds you have, interest payment frequency, and impacts to Age Pension or other Centrelink payments.  

You will also need to assess your own priorities. It may be more important to you to be mortgage-free (for example if you’re about to retire), in which case paying down the mortgage may be your priority.  

You’ll also need to consider what interest rates may do over time. While it is likely that more interest rate rises may be on the way to combat inflation early in 2023, this situation could change in coming months. Term deposits offer the benefit of locking in a fixed interest rate for your term, which will ensure your higher rate is protected if interest rates fall during that time. HISAs on the other hand, could fluctuate up or down depending on what happens with the official cash rate.  

It is strongly recommended to speak with a qualified and registered financial advisor before making any large financial decisions, particularly if your situation is more complex. 

For further reading: Savings.com.au, Australian Financial Review 

Please note: all insights and information provided in this article should be considered general advice for educational purposes only. As we’re unaware of your personal circumstances, information in this article should not be misconstrued as personalised financial advice. We recommend seeking advice from a qualified financial professional before making any major financial decisions.