We are frequently asked by clients whether it is better to use available funds to pay down debt or invest for the future.

At DecisionMakers, we regularly help clients navigate this complex decision. While the answer isn't always straightforward, understanding the mathematical principles and practical considerations can help you make an informed choice that aligns with your financial goals and risk tolerance.

The guaranteed return of debt reduction

Our fundamental position is that reducing debt offers a guaranteed win, whereas few investments can promise guaranteed returns. When you pay down your mortgage, you're essentially saving (think earning) a return equal to your mortgage interest rate - risk-free. This creates what we call the "cost of investing" - the opportunity cost of not saving that guaranteed interest. Consider this example: if your mortgage interest rate is 5%, any investment you make instead of paying down debt needs to generate at least 5% net return (after fees and tax) just to break even. Since investments carry risk, whilst debt reduction is guaranteed, you actually need a higher expected return to justify taking on that risk.

Calculating your required investment return

To determine whether investing makes sense, you need to factor in a risk premium, the additional return to compensate for the uncertainty of investing versus the certainty of debt reduction. Each investor's required risk premium varies, but let's use 3% as an example. Here's how the maths works:

Cost of debt: 5%
Risk premium: 3%
Required net return: 8%
Required gross return (before fees and tax): approximately 12%

 This means you'd need confidence that your investment could generate around 12% gross returns annually to justify not paying down the debt that incurs 5% interest cost.

The borrowing test

We often pose this question to clients: if you didn't have available funds, would you borrow money at your mortgage rate to invest in the asset you're considering? From a mathematical perspective, choosing to invest rather than pay down debt is identical to borrowing to invest. Most investors answer "no" to this question, which often clarifies their decision.

Why fixed interest investments don't work

Fixed interest investments are unlikely to outperform debt costs after fees and taxes. For fixed interest to offer rates exceeding typical mortgage rates, investors would need to accept significant risks, including capital risk, default risk, interest rate risk, and credit risk - defeating the purpose of choosing a "safer" investment.

Three exceptions to the rule

Despite our general preference for debt reduction, three scenarios may justify investing over debt repayment:

 1. Equity investments
A portfolio of 100% equities or other high-risk investments may outperform debt costs over extended periods. Companies must generate returns exceeding bank deposit rates to remain profitable, which historically has translated to equity returns exceeding typical mortgage rates. However, this requires accepting significant volatility and the possibility of negative returns in any given year.

2. Rental property investment
Residential rental property offers potential tax advantages, as debt costs can be offset against rental income. However, this isn't a passive investment; it requires active management. Investors typically rely on capital gains to achieve returns exceeding debt costs.

3. KiwiSaver contributions
Regular KiwiSaver contributions represent an exception due to employer contribution matching. When you contribute 3% of your salary, your employer typically matches it, providing an immediate 100% return on your contribution. This benefit alone justifies maximising employer contributions, though it only applies to regular PAYE contributions, not lump sum investments.

The psychological factor

We recognise that financial decisions aren't purely mathematical. Some clients find psychological benefit in building assets rather than simply reducing debt. While this approach may not be mathematically optimal, if it helps clients maintain their financial discipline and work towards their goals, we support it. The best financial plan is one you can stick to consistently.

The decision between investing and paying down debt requires careful consideration of your interest rates, risk tolerance, investment timeframe, and personal psychology. Generally, the mathematics favour debt reduction unless you're prepared to accept higher-risk investments that have realistic prospects of outperforming your debt costs after fees and taxes. Every New Zealander's situation is unique, and we strongly recommend seeking advice from an experienced financial adviser.

At DecisionMakers, our advisers are available to help you work through these decisions in a 45-minute complimentary consultation. They are available in person at our Takapuna or Tauranga offices, or via video or phone call. These conversations consistently help people clarify their financial direction and make more informed decisions about their financial future.

This article is the opinion of the writer and not intended to represent or replace personalised financial advice.