Rapidly rising interest rates have borrowers contemplating whether to direct more of their investing dollars towards paying down the mortgage, over other options like their share portfolio.

The Reserve Bank of Australia on Tuesday raised the cash rate by a further 25 basis points to 3.35% - a decade high - and signalled more hikes are on the way.

Assuming lenders pass on the latest rate rise in full, the average outstanding variable home loan rate will jump to 5.74%, according to RBA data, up from 2.86% in April 2022.

Standard variable rates – which fixed-rate borrowers typically default to once their fixed term expires – are now sitting between 7% to 8%. That could rise towards double digits if market expectations for a cash rate of nearly 4% are realised.

Soaring inflation – which hit 7.8% annually in the December quarter – is also eating into households’ real wages and eroding investment returns in real terms.

So, should investors consider contributing more towards the home loan? 

Should you reduce debt first?


Lagging inflation in the years preceding the pandemic had seen interest rates fall to historic lows, meaning borrowers could generally get better returns by investing in shares over paying down their home loan.

But as interest rates continue to rise sharply, so too does the case for homeowners to make extra mortgage repayments, says Drew Meredith, managing director at financial planning firm Wattle Partners.

That's because making additional contributions to a home loan generate a guaranteed, risk-free return.

At the same time, high inflation erodes investment returns. Returns in real terms are nominal returns less inflation. If inflation is zero and stocks rise 5%, that's a 5% real return. But with annual inflation now at 7.8%, a total nominal return of 5% including dividends represents a negative real return.

“Paying down your mortgage is the only guaranteed, risk-free return available; it further reduces future interest payments as well. One thing most people don’t take into account is that paying down your mortgage comes from after-tax dollars,” Meredith says.

“As a comparison, in order to generate the equivalent 5% to 7% return an investor actually needs to achieve close to double that in order to have the same after-tax result. That is, on the top marginal tax rate, you will need to generate a ‘risk-free’ return exceeding 10% in order to end up with an after-tax return equivalent to 6 per cent.”

Scott Keeley, senior financial adviser with Wakefield Partners, agrees householders should prioritise making extra mortgage repayments. However, says investors should still consider investing in shares where dividend yields are high enough.

“I think we are right at a point of equilibrium, where the returns on shares and the savings of paying down mortgages are similar. As such, there is no wrong or right answer as to what a person should do,” Keeley says.

“We’d always advocate a strategy with surplus income that does a bit of both – pay down debt and build wealth through investing,” says Keeley.

Keeley says he often asks his clients what the last thing is they think about financially before going to sleep.

“If it is levels of debt, then it’s difficult for me to suggest anything other than paying the mortgage down. If it’s how much they have in super or having [savings] for a rainy day, then we look at investment strategies,” he says.

“While it certainly more difficult to match the savings that investors can receive by paying down mortgages, many blue-chip shares are still offering yields equivalent to mortgage rates.

“The income returns on major bank hybrid securities (capital notes) are also similar to mortgage rates. These investments carry less risk than ordinary shares, but certainly couldn’t be classified as ‘almost risk free’,” says Keeley.

It's also important to remember the opportunity cost of missing out on compound interest.

Recent analysis by Morningstar shows paying more into an offset account can substantially reduce the total amount of interest paid over the life of the loan, however the effects of compounding can yield stronger returns on a share portfolio over the long term. 

Interest rates to rise further


According to data from the Australian Bureau of Statistics, mortgage interest costs for employee households jumped 26.6% over the December quarter, and 61.3% over the year.

And more pain is set to come, with RBA governor Philip Lowe flagging at least another two interest rate increases in the months ahead.

“The full effect of the cumulative increase in interest rates is yet to be felt in mortgage payments,” Mr Lowe said in a statement on Tuesday.

“Some households have substantial savings buffers, but others are experiencing a painful squeeze on their budgets due to higher interest rates and the increase in the cost of living. Household balance sheets are also being affected by the decline in housing prices,” he added.

“The Board expects that further increases in interest rates will be needed over the months ahead to ensure that inflation returns to target.”

The Commonwealth Bank expect the RBA to raise rates by 25 basis points at both its March and April meetings for a peak in the cash rate of 3.85%. However, the nation’s biggest home lender expects the RBA will cut official interest rates in the last quarter of this year and next year to avoid a hard economic landing.

ANZ and Westpac also expect a terminal cash rate of 3.85%, while NAB is forecasting 3.6%.

“We still see the risks to that peak as tilted to the high side given the momentum in inflationary pressure,” ANZ senior economist Felicity Emmett says.

Craig James, chief economist with CommSec, says the impact of rate rises will be felt hardest by homeowners with mortgages, but savers will benefit from higher returns on deposits.

“We always need to come back to the fact that a third of people rent, a third are paying off home loans and a third own their homes outright,” James says.

“The homeowners will receive a higher return on their savings. Renters, a similar situation – they will get higher returns and perhaps get to the goal of home ownership a little quicker. The borrowers will need to do some tighter budgeting, and that means tougher times for retailers,” James said.