Should I pay HECS early to get the 5% discount?
Your uni days are truly behind you. You have a job paying more than $50K p.a. and the ATO is deducting you HECS every month. This sucks, but you owe them money, so fair enough.
Did you know that the ATO offers a 5% discount on voluntary payment of HECS above $500? If you pay the ATO $1,000, they will wipe off $1,050 from your HECS debt. If this appeals to you, you may need to act fast. The government is proposing to terminate the 5% discount starting from 1 Jan 2016.
A post on Reddit got me thinking about whether it is good investment to take up the 5% discount. Or is it better to invest that money? Which option gives you maximum return for your hard earned dollar?
The answer to that question is different for everyone. It depends on two key factors:
1. How many years until you pay off your HECS?
2. What investments are you willing & interested to make with the money?
This table (the ticks) shows when it makes sense to pay early to get the discount. Generally speaking, pay early if:
- You will fully repay your HECS debt soon; and
- You prefer to not take risks with your investments.
HECS is a debt. The ATO charges a quasi-interest cost - a concept called “Indexation”. The Indexation rate is around 2.5% p.a. This means if you have $35,000 HECS debt this year, it will grow to $35,875 next year.
In essence, the ATO is giving you a loan at 2.5% interest rate. This is cheaper than any loan you can get anywhere as a consumer. If you don't repay the loan early, you can invest this money.
The 2 scenarios
Let's use a hypothetical scenario where Pete has diligently saved up $20K. The cash is sitting in a high saver interest account.
Based on his current salary and salary expectations, it will take him 5 years to fully repay his HECS under mandatory repayment (ie ATO’s auto deduction from his monthly pay).
Early repayment scenario - HECS discount
If Pete uses the $20K to pay his HECS, the ATO will give him a 5% discount. This will wipe off $21K off his HECS debt. This is same as getting $1,000 from the ATO for free.
The $21K debt would have accumulated $2,760 of interest (at 2.5% Indexation) over the next 5 years. The total value of savings from repaying early is $3,760 over 5 years.
Leave $20K in the bank
If Pete left this cash in the bank, it would earn interest. We can assume that he will get 3.70% interest for the next 5 years. The interest income will be taxed at his personal tax rate of 32.5%
The interest rate here is higher than the current rate offered by banks, which is around 3.00% to 3.20%. However, for the purposes of this comparison, we have taken the last 10 year's historical returns vs interest rates offered by banks.
Over the next 5 years, Pete will make $740 - $820 of interest p.a. but pay around $250 tax on that interest. This will leave him with $500 - $550 after tax return. The total value of after tax return for the 5 years is $2,625.
Clearly, under these assumptions, Pete should pay the HECS debt early as he would be $1,651 better off over 5 years.
A different investment approach
This story might play out differently if Pete decided to invest his $20K in other forms of investment. For example, if Pete invested the money in the Aussie share market, where the last 10 years’ average annual return is 9.2%.
By investing in a riskier asset class (like shares), returns in any given year might be negative and different to the expected return of 9.2%. But over the long run, the share market generally moves upwards.
In this scenario, Pete would make $1,200 to $1,600 p.a. after tax for the next 5 years. Even if he had to pay tax on the return every year, he would come out $3,271 ahead by investing the money. In fact, Pete will probably pay much less than 32.5% tax on the share returns. This is becausee majority of the returns will be discounted capital gains tax.
An interesting method to roll out this investment strategy is to buy an ETF of the entire Aussie share market. With one share of the ETF, you get exposure to the entire share market.
The key difference here is that the return from the share market is so much higher than the cost of the HECS loan. This shows that the more risk and higher returns you are willing to accept, the more likely that repaying HECS early doesn’t make sense.
Tick tock, tick tock
Beyond risk, there is also an important element of time. The shorter the time you have to repay your HECS in full (via mandatory repayment), the more compelling it is to pay early.
Let’s change the assumptions. Suppose Pete will repay his entire HECS debt in 1 year under mandatory repayment. In this case, Pete will only get 1 year worth of 9.2% return from the stock market. This is $1,242 after tax return.
Compare this to early payment discount. He would get $1,000 immediate discount, plus save $525 of interest (Indexation) next year. So if he repaid early, the total value is $1,525. This is more than the return from investing in the stock market.
What does it all mean?
From high level assumptions, it does not make sense to pay early:
- the longer the time you have to pay back HECS under mandatory repayment;
- the more risk you are willing to take with your investments (assuming you will invest that money instead of spending in on a Bali holiday)
Of course, this is only looking at things from a 100% financial perspective. There is nothing wrong with enjoying life in your 20s. Spending that money to travel the world, have fun, etc.
It is a good idea to start formulating savings and investment strategies now. You don’t want to have fun only in your 20’s. Having an investment plan now will help you afford an exciting life in your 30’s, 40’s, 50’s, even 60’s and beyond.
Sources: Russel and ASX, 2014 Long-term Investing Report