Australians looking to improve their financial position may be wondering where to spend their hard-earned dollars.
Two viable options are to pay down the mortgage or buy shares.
Mortgage vs shares
During the pandemic, average mortgage rates in Australia reached record lows, with many lenders offering loans as low as 2%. During this environment, it made little sense to pay down the mortgage as quickly as possible.
However, mortgage rates have risen substantially over the past few years. According to Money.com, the average mortgage rate for owner-occupiers in Australia is around 6.42% per annum. While this is far above pandemic levels, it is roughly in line with the long-term average.
In February, the Reserve Bank of Australia (RBA) began cutting the cash rate. With inflation continuing to moderate and growth expected to slow, major banks are tipping that more interest rate cuts are on the horizon. For example, Commonwealth Bank of Australia (ASX: CBA) predicts the cash rate will drop from 4.35% to 3.35% by the end of the year.
While the magnitude and timing of future rate cuts are far from certain, mortgage rates are likely to come down this year, which will reduce the appeal of paying down the mortgage.
Australians may therefore be wondering whether shares offer superior financial returns today.
According to the 2024 Vanguard Index Chart, Australian shares have returned 9.1% over the past 30 years. For international shares, the return is even higher, with an average return of 11.1% over the past 30 years.
However, the current price-to-earnings (PE) ratio for the S&P/ASX 200 Index (ASX: XJO) is around 20 times earnings. This is above its historical average of 15 times, suggesting future returns may be below the historical average. Similarly, the PE ratio for the S&P 500 Index (SP: .INX) is 28 times earnings, well above its long-term average of 18.
Overall, shares appear to be the more compelling use of funds. However, investors should also factor in their view on the future of interest rates and whether they believe the current share market is overvalued, as this will impact returns.
Other considerations
Additional personal circumstances are likely to influence whether paying down the mortgage or buying shares is more appealing.
Firstly, the absolute mortgage size is largely dependent on the size of the home loan. The average new home loan size is largest in New South Wales and lowest in the Northern Territory. This reflects the median values of properties across the country. Those with a larger mortgage may be more comfortable paying it down more quickly, even if the return is slightly lower.
Secondly, personal tax rates. Share market returns are quoted in pre-tax figures. Investors must pay tax on dividends and any realised capital gains. Tax rates in Australia range from 0% on income up to $18,200, to 47% plus a 2% medicare levy for top income earners. There is also a 50% capital gains discount on shares held for more than 12 months.
For an individual paying 30% tax, this means that a 9.1% pre-tax return becomes 6.4% post-tax on dividends and short-term capital gains. With this figure very close to the current mortgage rate, the deciding factor may come down to the individual investor's personal circumstances.
