A third way that refinancing can help is that you may be able to substantially increase your long-term wealth.
There are two extremely important concepts involved in this strategy that I will briefly outline:
- Compounding interest
- Salary sacrificing into superannuation
I have previously discussed compound interest at length and how it is a Golden Rule of investing that assists your money to grow faster as time passes. That is, your money grows at an increasing rate over time.
You will note that over time the cumulative interest earned by the investment dwarfs the initial investment – it has compounded over time. Each year interest is earned and this is added to the balance. Then interest is earned on the new balance and added again. And so on it goes.
Three key requirements for compound interest to work
There are three aspects to compound interest that will determine the size of the benefit to you:
- Starting balance,
- time period, and
- regular contributions.
1) Starting Balance
For example, while two different investments may earn 10%, if one had a starting balance of $1,000 and the other had a balance of $100,000 then the second one will have a greater DOLLAR impact with compounding.
|Start Balance||Earnings at 10%||Balance after 1 year||Balance after 10 years|
One thing becomes apparent – if you have a higher initial balance then the DOLLAR effect of compounding is pronounced. In fact, the first investment of $1,000 needs to compound over 58 years to get close to the balance of the second investment after 10 years.
This leads to the second important aspect of compounding – timeframe.
The longer you allow an investment to compound, the more it grows in dollar terms each year. Eventually a point will be reached where the interest it earns in one year will be more than the starting investment amount.
In the chart below by year 26 the investment earns $108,000 (more than the starting balance of $100,000). But if you delay the start of the investment by 10 years, by year 26 your investment will only earn $46,000 in comparison.
This results in your investment growing at a much slower rate.
This is even more important if you intend to retire and start selling down the investment to provide funds for living. Starting late means you never give your investment enough time to allow the magic of compounding to work.
3) Regular contributions turbocharge wealth creation
The third aspect to compounding is making regular contributions. If you start investing late you don’t give your investment enough chance to compound and grow rapidly in time.
BUT, in the example above where you start 10 years late, if you are able to make regular contributions of $15,000 per annum, then it is quite possible to close the gap despite starting your investment 10 years later.
The downside with this is that you are required to contribute much more of your own money to play catch up. The chart below highlights that while you are able to get close to the final balance of an investment held for 30 years, it requires you to contribute 4 times as much of your own money to do so ($400,000 vs $100,000).
Essentially, that is extra cash that you wouldn’t be able to spend on the things that matter to you in life more or to build further wealth.
So ideally you would start investing as soon as practical AND make regular contributions. Even small contributions are going to make a significant difference to your ending balance if you start investing early enough.
So how does all this finance-babble actually help you?
You actually have an investment that probably has a decent balance already that is being contributed to on a regular basis – your superannuation.
Superannuation as wealth creation
In Australia, most employees will have a superannuation account where employers make regular contributions to. For example, somebody that has been in the workforce for 15 years, it would be reasonable to assume:
- $75,000 as a balance,
- regular contributions of $5,000 per annum, and
- another 25-30 years remaining in the workforce.
These 3 points tick off the key requirements to have compound interest work for you to create future wealth.
What if you are able to increase your regular contributions with no effect on your current lifestyle?
That would enable you to turbocharge the growth of your superannuation balance over a very decent timeframe.
Taxation – the key advantage of superannuation
The biggest advantage of funds within the superannuation system is that they are taxed at lower rates. A maximum tax rate of 15% applies to:
- investment earnings inside superannuation, and
- contributions made before tax (ie deducted from your pay before tax is taken out).
Compare this to normal tax rates:
|Income||Income Tax Rate||Super Tax Rate|
|0 – $18,200||Nil||15%|
|$18,201 – $37,000||19.0%||15%|
|$37,001 – $90,000||32.5%||15%|
|$90,001 – $180,000||37.0%||15%|
|$180,001 – $250,000||45.0%||15%|
For example, if you earn $80,000 per annum you are in the 32.5% tax bracket. Ignoring Medicare, for every $100 you earn you lose $32.50 to taxation and end up with $67.50 in the hand.
Rather than taking the income via your pay run, you can elect to contribute it into superannuation before payroll withholds the $32.50 tax.
This is known as salary sacrifice because you are sacrificing your income by contributing it directly into your superannuation. This pre-tax contribution into superannuation is only taxed at 15%.
|NET amount on $100 income ($80,000 salary)|
|Take as income||$32.50||$67.50|
You end up with more net income by salary sacrificing the funds into superannuation. But wait – there’s more! If the $67.50 is invested outside of superannuation any earnings would be taxed at the marginal tax rate of the income earner (32.5% in this case). In contrast, earnings on the $85 inside superannuation are only taxed at a maximum of 15%.
How does salary sacrifice and refinancing create wealth?
Most of our clients refinance their home loans to significantly reduced interest rates. While the savings differ depending on individual circumstances, you are able to take advantage of the extra cash flow to build wealth by salary sacrificing your savings.
For example, say you refinance and your home loan is $100 cheaper per week. The table below shows how much income you would normally need to earn in order to pay that extra $100 per week off your old home loan with the higher repayments.
|Income||Income Tax Rate||Income to earn $100 NET|
|0 – $18,200||Nil||$100|
|$18,201 – $37,000||19.0%||$123|
|$37,001 – $90,000||32.5%||$148|
|$90,001 – $180,000||37.0%||$158|
|$180,001 and over||45.0%||$181|
If you earn $80k per annum you need to earn $148 to end up with $100 after your payroll deducts tax. Similarly, if you refinanced to a home loan that was $100 cheaper each week, then you don’t need to earn that $148 anymore – it is spare income. What could you do with that spare $148? Options include:
- Let payroll deduct tax and you end up with an extra $100 payrise to live your life more
- Let payroll deduct tax and then you pay $100 as an extra home loan repayment to own your home sooner, or
- Salary sacrifice the whole $148 into superannuation.
Above all, the benefit of approach number 3 is that the $148 will only have 15% tax taken out rather than 32.5% (for someone earning $80,000).
Refinancing can build your super and your wealth
This means you actually have $125 added to your superannuation investments. If you chose to take the money and invest outside of super you would only have $100 to use. Better yet, earnings on that $125 will only be taxed at a maximum of 15% inside superannuation. Investment earnings outside super would be taxed at 32.5% for an $80k wage-earner.
The chart above shows the difference that can be made by salary sacrificing and how the tax advantages compound your investment over time. The assumptions are:
- Starting super balance of $75,000
- Refinance savings of $100 per week and a tax rate of 32.5% (Medicare excluded)
- Earnings of 7.8% p.a
- 30 year timeframe
- Employer contributions not included – only the difference between sacrificing the refinance savings are considered. Furthermore, in reality the end balance would be higher when employer contributions are included.
Certainly, you can see that by refinancing your mortgage to a lower interest rate you have the opportunity to build your wealth significantly. The best part about this strategy is that it doesn’t require any contribution from you above what you are currently paying on your mortgage. You also don’t need to take any funds from other areas of your finances. It simply redirects the savings from refinancing your home loan.
What determines the benefit of your refinance?
The benefits provided by this strategy are determined by 3 things:
- your starting balance,
- the size of your regular saving obtained from refinancing, and
- finally, your timeframe until retirement.
Therefore, the benefit is magnified the larger the starting balance, the greater your savings from refinancing and the number of years until you retire.
Unfortunately, the downside is that the money is locked up in superannuation and cannot be accessed until you satisfy a condition of release – usually retirement.
If you are interested in building your wealth through refinancing then you have a couple of options:
- check out our REFINANCING CALCULATOR , which shows you the benefit of salary sacrificing your savings over the remaining term of your current loan., and then
- contact Moneybright or call 1800 90 88 42 to organise a phone meeting.