With interest rates rising, many of you are probably wondering if it would be beneficial to pay more off your mortgage. The good news is that if you have sufficient funds, and you are in a high personal tax bracket, it could be your best investment right now. Let me explain why.

While a vast number of mature Australians with no mortgage and cash in the bank, or invested in credit income funds are cheering the positive impact of recent rate rises on their cash interest income, for many the rate increases have heaped burning coals on the already inflation-fueled costs for fuel, power, and other general living expenses. 

But there could be a mathematical silver lining even for those with a mortgage and confronting increased mortgage rates.

Last week the Reserve Bank of Australia (RBA) raised the cash rate by a further 25 basis points to 3.35 per cent. While the cash rate hit a ten-year high, the RBA also indicated more rate increases will be necessary to stamp out inflation.

Meanwhile, lenders are sharpening their pencils and preparing to pass on to borrowers the additional rate increase. It’s no coincidence shares in Commonwealth Bank (ASX:CBA) – which has the largest mortgage book in Australia – hit an all-time high last week of $111.15. 

If lenders pass on the rate rise in full, RBA data suggests the average variable home loan rate will jump to 5.74 per cent. According to Canstar, comparison rates for a principal and variable interest mortgage, with an 80 per cent LVR, currently sit between 4.35 and 5.20 per cent. The average variable rate was 2.86 per cent a year ago.

It all sounds very gloomy, and the experience is entirely foreign to many young people who have never witnessed rising rates, let alone a recession or associated job losses.

According to the RBA, property owners in aggregate used the period of ultra-low rates to get ahead of their scheduled payments. The result is a buffer, allowing mortgagees to be on schedule even if they now reduce their payments.

Do you reduce payments?

One question worth asking however is whether one should reduce repayments or do everything possible to make extra repayments.

From an investment perspective, making extra repayments (I understand not everyone is able to do so), is entirely sensible in a world of rising rates. We’ll explore the impact of inflation separately, in a moment. And the higher the individual’s tax rate, the more sensible the idea of paying down the mortgage faster becomes.

That’s because interest on a mortgage funding the purchase of your primary place of residence is not tax deductible (unless of course, you rent out a proportion of your home, that portion is). For this exercise, let’s assume you don’t rent out any portion of your home.

Interest expenses on a home mortgage aren’t tax deductible. You are paying the mortgage interest with after-tax dollars. If we ‘gross up’ the interest rate for the tax you paid before you gave your money to the bank, to make the mortgage payment, we obtain a rate that is the equivalent rate you require from your other investments to be in the same position.

Let me explain.

Let’s say you earn over $120,000 but less than $180,000. On every dollar you earn over $120,000 you are paying 37 per cent in tax. If you also have a mortgage with a variable rate of, say, 5.74 per cent, a quick calculation will display the minimum return you need to generate on another investment before it makes sense to invest there, rather than make additional mortgage payments.

If we divide 5.74 by one minus the tax rate of 37 per cent (0.37) we arrive at 9.11 per cent (5.74 per cent / (1-0.37) = 9.11 per cent)

If the RBA is correct and the average variable rate rises to 5.74 per cent in the coming weeks, those individuals earning more than $120,000 per year, and with the ability to direct additional payments toward their mortgage, need to find an investment generating 9.11 per cent elsewhere to be better off than making those extra payments.

Additionally, paying extra dollars off the mortgage is equivalent to a ‘guaranteed’ 9.11 per cent return. That’s because when an additional payment is made there is zero risk the return is anything but 9.11 per cent. In other words, making additional payments on the mortgage is offering a guaranteed pre-tax return of 9.11 per cent.

And for those few individuals earning $180,001 or more, their marginal tax rate on every dollar earned above that amount is 45 per cent. The equivalent pre-tax return required elsewhere, using those dollars earned above $180,001, is 10.44 per cent.

The calculation explains why we say, ‘for someone earning over $180,001, they are generating a guaranteed return of 10.44 per cent by paying off their mortgage faster’.  

Some commentators will also draw inflation into this discussion observing that inflation erodes investment returns. With inflation the root cause of higher rates it is understandable that some choose to include it when examining whether additional payments should be made against a mortgage.

By way of background, so-called ‘real’ returns are determined by taking the nominal return and deducting the inflation rate. Without inflation (when inflation is zero) real returns and nominal returns are equal.  With inflation today at 7.8 per cent and, for example, a one-year term deposit earning just four per cent, the real return is a negative 3.8 per cent (4 per cent – 7.8 per cent = – 3.8 per cent). 

Some suggest inflation makes it even more attractive to secure the guaranteed return available from paying down the mortgage faster.  But this argument fails to acknowledge inflation impacts all investment returns. The real return from paying down the mortgage faster is also eroded by inflation. And let’s not forget assuming debt in pre-inflation dollars and paying it off in post-inflation dollars makes holding the debt an attractive proposition.

For this discussion however there is a clear silver lining to the higher rates: home buyers on higher personal tax rates, and who can make additional payments, are guaranteeing themselves an attractive relative return by making those extra repayments.

The Montgomery Funds owns shares in the Commonwealth Bank of Australia. This article was prepared 10 February 2022 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade the Commonwealth Bank of Australia you should seek financial advice.