Should you pay off your home loan before you invest?

PAYING off your home loan sounds like a great idea, so does investing for your future. If you don’t have enough money to do both, and a lot of people don’t, which do you go for?

Most people are actively paying off both the principal and the interest, because that’s what they’ve always done.

But is that the best way forward for your investment property strategy?

Metropole, Australia’s leading firm of property strategists summarise a test case with would be investors Joanne and Richard (names changed for privacy).

They have had a home loan for three years and have decided to look into property investment.

Joanne has been told that because their home loan is ‘bad debt’, it’s best to pay it off first and create a bigger margin in their income, before taking out loans for other properties.

However, Richard thinks it would be best to pay interest only on their home loan and use the amount they would have paid as principal towards some investment properties.

Who’s in the right here?

We’ll get to that in a moment, first, clients often tell us that their financial advisors counselled them to pay off their own loan first before investing in property.

It’s true that home loans are a debt we want to get rid of but we call this necessary debt, not bad debt.

Let’s look at Joanne and Richard’s situation and compare their options.

They have a 30-year home loan and are paying off the principal at an average of $10,000 a year.

This means in ten years, accounting for a little compounding, they will have paid somewhere in the vicinity of $120,000-$150,000 off their loan.

Eventually they’ll pay it off, but it’s a very slow method to getting there.

Option two paints a very different picture.

Let’s say they borrowed some money (using the equity in their home as a deposit) and bought an investment property for $500,000, which increased in value over ten years to become worth $1 million.

In 10 years, they’ve made $500,000 profit (at a growth rate of just over 7%).

So, in the first scenario, they have paid, at most, $150,000 into their home loan.

In the second, they are $500,000 ahead because they used their money to service a loan for their investment rather than to pay down their home loan.

The end result?

Even if they didn’t invest in any other properties, they are far ahead and even though they still have a home loan, with inflation their loan is not as big a burden, and with the appreciation of the value of their home it’s a much smaller percentage of its value.

In other words, their loan to value ratio would be much lower and manageable.

The short story is, if Richard and Joanne wait to buy a property until their own home loan is paid, they are missing out on three decades worth of future capital growth in a property they could have invested in.

That is why when people ask, “When’s the best time to invest in property?” our answer is always: as soon as you can!

Property investment is about the long-term.

It’s not about immediate wealth, and it’s not a get-rich-quick scheme.

As we say, sure paying off your home loan is an admirable goal, but it’s a very slow process.

It’s a bit like putting a little cash into a savings account each week.

Yes, it’s a strategy to earn interest, but there are far better and more profitable ways to manage your money.

Many Australians are still paying off home loans long after retirement, which is never an idyllic way to spend your hard-earned twilight years. The ideal way forward is to plan to pay off your home loan as soon as possible, but don’t do it at the expense of greater wealth in the long run.

You want to be buying a speedboat at 65, not funnelling your retirement money into your mortgage!

Remember, if you wait 10 years to invest in property, you may miss a whole cycle of capital growth.

This will not only impact your bank balance but will rob you of an opportunity to increase your asset base and work towards a financially healthy retirement.

But there’s one big provision, these recommendations are based on the assumption that you buy “investment grade” properties, ones that exhibit superior capital growth.