Let’s assume that you unexpectedly come into some money, such as an inheritance, or you managed to tuck away part of your salary each week that has built up to a sizeable chunk of cash. You are currently making the minimum loan repayments against your residence, and are now wondering if you should use this extra money to pay down your debt further or invest?

The answer seems simple. If you believe an investment can generate more than you are paying in loan interest repayments, let’s assume 7% per annum, then you should invest. Conversely if you cannot generate investment returns over and above what you are paying in interest, why bother?

However, when evaluating this decision, it is important to compare apples with apples and to remember that the savings you have built up in your bank account are tax paid money. For example, if you managed to save money from your regular salary, you have already paid tax on this money.

So if your home loan repayments are 7% per annum, you may think that you only require 7% from your investments to break even. However this is not the case as a 7% return from your investments is a pre-tax return. Once tax is taken into consideration, a pre-tax return of 7% is in fact less than that.

So what return would you have to generate from your investments to justify investing rather than paying off your home loan with an interest rate of 7%?

The answer depends on what marginal tax rate you fall into. If you are taxed at the top marginal rate of 46.5%, your investments would have to generate a pre-tax return of 13.08% per annum to provide you with an after tax return of 7%. If you are on the 31.5% tax rate, you would require a pre-tax return of 10.2% per annum.

The long term average return of the share market is around 11% per annum. Therefore the average after tax investment return for someone on 31.5% tax rate is around 7.5%. For someone on the 46.5% bracket the average net return falls to 5.9%.

So if you were to receive a net investment return of 7.5% or 5.9% from your investments to repay your home loan of 7%, you must ask the question, is it worth it? Given how the after tax numbers stack up, I would suggest not in this instance.

The repayment of non-deductible debt such as a home loan is effectively a guaranteed return. You are guaranteed to save 7% per annum in interest repayments. Whereas investing into growth assets such as shares and property carries risk and the rate of return is uncertain.  

So, if you are planning to invest a sum of money and also have a home loan, it would be worth remembering that it is always best to pay down debt as quickly as possible. In any case, it might help to discuss the pros and cons with your adviser first.