Reduce the debt and risk

Jennifer and Toby are in a strong financial position, so shouldn’t be discouraged by adverse property price movements over the short term. What really drives wealth creation is the ability to save, so their strong savings habit will hold them in good stead.

The decision to either pay down debt or establish an investment portfolio is a dilemma faced by many. In the early stages of wealth building with a young family, the priority should be to remove non-deductible debt first.

So Jennifer and Toby should direct their weekly savings to repaying the mortgage on their family home. As they point out, an investment would need to generate an after-tax return greater than the 3.95% interest cost of their loan for it to be worth their while.

For an investment to be a more attractive option, it would need to generate a before-tax return of more than 6.48%pa, assuming tax would be payable at their marginal rates.

While this is not a high hurdle to achieve with equity investments over time, with plans to upgrade the family home within the next five years their time frame is too short to ride out the volatility of investing in equity markets. Such a strategy is too risky and exposes Jennifer and Toby to the chance of losing capital if they had to sell at the wrong time in a market cycle. So the safer route of simply reducing the non-deductible debt makes sense.

For an equity-type investment to be worthwhile, six or more years are needed to give markets enough time to recover from downturns.

Once Jennifer and Toby’s non-deductible debt represents less than 50% of the value of their home they could look at other longer term wealth-building options such as an equity-type investment or perhaps making additional contributions to super.

Future investment decisions should look to improve the diversification of their wealth. They should avoid becoming too reliant on the returns of a particular asset class, which can make wealth more susceptible to market fluctuations. Spreading wealth across different asset classes lowers the risk of investing.