So, you have some spare money. Maybe you’ve just received a lump sum of cash. An elderly aunt might have left you an inheritance, or you’ve sold the boat. Or maybe you’ve just realised that you’re spending less than you earn and that the surplus has started to accumulate in a bank account.

Either way, you have some spare money and you also have a problem. What are you going to do with it? Of course, this is a good problem – spare cash is not a bad thing! But you want that money to do something useful for you. What you do with that spare money depends on you, your situation, and your objectives.

Save money on interest

Whether you have a mortgage or not is one of the most important aspects.

If you do have a mortgage, a quick and easy option might be to use that spare cash to repay some of the mortgage. This can apply whether that cash is a lump sum or extra income surplus. Either way, you can use that money to reduce the mortgage. If you use your surplus to increase your mortgage payments or use a lump sum to reduce the balance, you’ll pay the mortgage off quicker. You’ll also reduce the total amount of interest you’ll pay on the loan.

This might appeal to you – less time with that mortgage monkey on your back and saving on cost is a great thing to do. But is it the best thing to do? Should you invest it, or put it into your KiwiSaver account? These are age-old questions. Whether to repay the mortgage before you start to invest has been pondered for as long as I have been in finance.

How much can you save?

The answer largely comes down to the interest savings you can make if you pay off the mortgage, compared to the investment returns that you’d expect to receive if you invest the cash. On top of that, you also need to think about the risks you’ll face for each.

The case for paying off the mortgage

First, let’s think about paying off the mortgage. The interest that you’d save will be the interest you’re paying on the mortgage now. Let’s say you have a loan at 4.5 per cent a year.

To pay off all, or part of, that mortgage means that you’ll save 4.5 per cent a year. Remember, you have to pay that with tax-paid dollars and we’re assuming that there are no fees to pay, so that’s not a bad saving. There’s no risk paying off the mortgage.

However, there may be some ‘break fees’ to pay if you’re on a fixed rate. If these apply to you, you may want to wait until the fixed term has expired. However, these costs aside, there’s no risk or cost paying off the mortgage. You’re certain to save 4.5 per cent.

The case for investing

The alternative to repaying the mortgage is to invest your lump sum or surplus. To do as well as paying off the mortgage, you’d have to get an investment return of 4.5 per cent a year, after tax and fees. That sort of rate of return is possible, but not without some risk.

To get a return of 4.5 per cent a year after fees and tax, you’d probably have to invest as a ‘growth’ investor. This would mean putting your money in a growth fund, with more weighting towards the riskier shares and property, say 60 per cent. This means you’ll take on more risk, but you’re more likely to get better returns over time.

After you’ve paid fees and tax, you could expect to be about as well off as the people who paid off their mortgage. However, there is risk in investment – there always is.

That growth portfolio will have its ups and downs. The fund should be well diversified, so it’s unlikely you’ll lose everything. But over the long term – say 10 years – there’ll be times when the markets are down, and you might wish you’d paid off the mortgage. You could take on more risk and invest in an aggressive portfolio (80 per cent in shares and property and 20 per cent in bonds and cash).

That sort of portfolio would probably give you better returns, and you’d be better off than if you’d repaid debt. However, that riskier portfolio would mean you have to expect a lot more times when the portfolio would lose money. When you adjust for risk, investing that spare money may not be a good idea. Paying off the mortgage gives a net saving of 4.5 per cent a year, but you’d have to stick your investment neck out quite a bit to beat that.

Three exceptions

Paying off the mortgage before you start to invest is the best policy for most people. Any spare money you have should be used to reduce your mortgage. However, there are three exceptions:

KiwiSaver: Don’t wait until the mortgage is gone before you join KiwiSaver. KiwiSaver is different, because of the extra contributions from employers and from the government. This free money makes KiwiSaver a very good deal, one that’s far better than using the same money to pay off debt.

oin KiwiSaver whether you have a mortgage or not. However, unless you’re close to buying your first home or close to retirement, I say to only contribute the minimum amount, to get the maximum employer and government contributions. That’s because KiwiSaver is not a ‘liquid investment’. It’s locked in until you buy a first home or retire, and it’s possible you might need the cash at some time. Even if you’re self-employed, you should still join KiwiSaver and add NZ$1,042 each year. If you do that, you’ll get the maximum government contribution of NZ$521 every year.

Good debt: The numbers, and therefore the advice, is different if you have debt that’s tax-deductible. Perhaps you borrowed to buy a rental property, or you have a business. In effect, debt is cheaper if you can deduct the cost of it, so the investment return you’d have to look for is correspondingly lower. If you’re on the top tax rate of 33 cents, that 4.5 per cent threshold that you’d have to beat comes down to an investment return of just 3 per cent a year, after tax and fees. That’s easier to beat and could be done with lower risk.

Aggressive, skilled investors: There are people who invest aggressively and back themselves to get outstanding investment performance. They may buy rental property, which they gear up with more debt, or they may own a very targeted share portfolio. Often these strategies will be quite risky, and their plans may or may not always work out. But there certainly are people who will beat the market often enough to make investing that spare cash worthwhile.

What’s the best option?

Even with interest rates as low as they are at the moment, most people are best to put any spare money into their mortgage. This will pay the mortgage off faster and, most likely, save you thousands of dollars in interest over the life of the loan. Investing spare money could possibly make you better off than paying off the mortgage – but for my money, it’s not worth the risk.

Published 28 November 2019

Martin Hawes is the chair of the Summer Investment Committee. The Summer KiwiSaver Scheme is managed by Forsyth Barr Investment Management Ltd and a Product Disclosure statement is available on request. Martin is an Authorised Financial Adviser and a Disclosure Statements is available on request and free of charge at www.martinhawes.com. This article is general in nature only and has not taken into account any particular person’s objectives or circumstances. We recommend you speak with a financial adviser before making any decisions.

This article does not contain any financial advice and has not taken into account any particular person’s circumstances. Before relying on it, we recommend you speak with a financial adviser. This story reflects the views of the contributor only. Content comes from sources that we consider are accurate, but we do not guarantee that the content is accurate.