How low interest rates can help build your super

non-concessional contribution

If you have a couple of thousand dollars surplus cash each month, what is the most effective way to invest it?

You could invest in the share market, repay your mortgage(s) or invest in property.

But there’s another strategy that might be particularly more attractive, especially since mortgage interest rates are ridiculously low at the moment.

You may not want to repay debt or invest in shares or property

It certainly doesn’t cost a lot of cash flow to borrow to invest in a residential property at the moment. However, it is difficult to buy an investment-grade property for less than $600,000, which means you need to borrow a relatively large amount of money. If you already own some direct property, you may not feel comfortable borrowing this amount of money.

Repaying debt at the moment might only save you 3% p.a. in interest costs, which isn’t terrible, but it’s hardly a big return on your investment.

And of course, you could invest your cash flow in shares in your personal name or family trust. But if you are relatively close to retirement (within 10-15 years), investing inside super could be a lot more tax effective.

So, what about borrowing to fund additional contribute into super?

First, let me clarify how you can contribute money into super.

What are non-concessional contributions?

There are two types of super contributions being ‘concessional’ and ‘non-concessional’.

Concessional contributions are more commonly utilised because these contributions are made pre-tax i.e. you receive an income tax deduction for them. You can make concessional contributions via salary sacrifice or by making a personal contribution into your super account. These contributions are taxed inside super at a flat rate of 15%.

Non-concessional contributions are after-tax contributions i.e. they do not affect your income tax position (no tax deduction). As such, they do not attract any superannuation taxes either (no contribution tax).

If your super balance is less than $1.4 million at the beginning of the financial year, you can make non-concessional contributions of up to $100,000 per year. Alternatively, you can bring forward 3 years of contributions into one i.e. contribute $300,000 in one year and nil for the following 2 years.

This page on the ATO’s website provides more information.

Borrowing to make non-concessional contributions isn’t normally a good idea

If you borrow to make a non-concessional contribution into super, the interest in respect to the loan is not tax deductible. This makes it an expensive strategy when interest rates are higher than they are today, and therefore rarely worthwhile.

However, with interest rates so low today, I thought I would consider whether borrowing to make non-concessional contributions is an attractive strategy.

My financial analysis

Assuming an investor has a surplus cash flow of $2,000 per month, they could borrow $200,000 today and contribute the full amount into super (i.e. make a non-concessional contribution). They could then direct their monthly surplus cash flow of $2,000 towards repaying this loan. The loan would be fully repaid within 10 years.

As noted above, interest charged in respect to this loan will not be tax deductible.

I have assumed the investor fixes their interest rate for 5 years at 3% p.a. After the 5-year fixed rate expires, I have assumed the variable rate has increased to 4% p.a. and then increases each year by 0.50% to reach 6.5% p.a. at the end of the 10 years.

I calculated that the value of the total interest paid over 10 years in today’s dollars (assuming inflation at 1.5% p.a.) is approximately $32,000.

What are the results?

After 10 years, the investor is approximately $51,000 better of in today’s dollars as a result of borrowing the $200,000 now, compared to investing it progressively over the 10-year period (i.e. projected future balance of $323,000 versus $272,000).

Therefore, after subtracting the interest cost ($32,000), the investor is approximately $19,000 better off in today’s dollars.

The investor is approximately $50,000 better off after 20 years. I have used conservative investment return assumptions of 3.5% p.a. of income plus 3.5%p.a. of growth. If actual returns are higher, the differences could be substantially more.  

Admittedly, these are not huge numbers. However, this additional wealth is accumulated as a result of this chosen strategy, which doesn’t really cost you very much time or money to implement.

No capital gains tax

Remember, one of the benefits of investing inside super is that income is taxed at a flat rate of only 15%.

And, if you do not sell any investments until after you retire, it is very possible that you will pay no capital gains tax. This provides substantial future tax benefits compared to investing in your personal name.

Is it a good time to make this investment?

Given recent volatility in share markets, it could be a good time to make this investment, particularly if invested well.

I’m not confident that in 6 months we will look back at June 2020 and consider it a smart time to invest. However, I have a much higher level of confidence that in 6 years from now (for example) we’ll wish we had have invested more in June 2020. That is a very important point. What happens to markets over the next few months is immaterial – no one can pick markets so it’s not worth worrying about.

What is absolutely critical is that your average investment returns are healthy over the next 10 and 20 years.    

Double your downsizer contribution

The government allows people to contribute up to $300,000 from the proceeds when downsizing their home. These contributions are not included in the non-concessional cap.

Therefore, if someone plans to downsize their home in 3 years’ time, they might borrow $300,000 today to make a maximum non-concessional contribution. Then in 3 years’ time they can repay this loan using their home’s sale proceeds; make a downsizer contribution; plus another non-concessional contribution into super at that time. Doing so effectively allows them to shift up to $900,000 of their home’s equity into super.

Don’t invest it all at once!

I would almost never recommend investing $200,000 into super in one hit. Instead, I would spread the timing risk and invest the monies in a of number tranches over several months. Dollar cost averaging is an important risk management strategy.

What could go wrong?

No investment strategy is without risk. It is important to first consider all the things that could go wrong, before you become enamoured with all the things that could go right.

Borrowing to invest magnifies returns. Therefore, if you borrow to invest and your super fund does not deliver the investment returns you hope for, is it very possible that you could be worse off.

Also, if interest rates rise at a faster rate than what I have assumed, this strategy will not produce the benefit I have projected.   

Make sure you have a high-quality super fund

The quality of your assets directly impacts the quality of your investment returns. You cannot expect good returns from average quality assets.

A quality super fund is one that has strong historical performance; adequate transparency and accountability; and low fees. The investment returns that many of the big-name funds produce can vary significantly over long periods of time. Investing in the wrong fund can cost you hundreds of thousands of dollars in missed returns. 

‘Strategy’ is free money

Often a small enhancement to an investment strategy can produce substantial benefits for little to no additional cost. I regard this as ‘free money’ because its available to anyone with the right advice for no additional risk or cost.

As the saying goes, “you don’t know what you don’t know until you know it”.