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KiwiSaver: How Does Mortgage Diversion Work?

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Contributor:
Mary Holm
Mary Holm

Question:

I am trying to understand the logic of mortgage diversion.

I know the rules have been relaxed, so even if I have a revolving credit component of my mortgage I can now divert up to 50 per cent of my contributions, after 12 months in KiwiSaver. But why would I?

Let's say I earn $48,000 per year, and I currently contribute 4 per cent, $160 per month, to KiwiSaver.

The rules allow me to divert half of this, $80, to offset my mortgage. Most banks take this as an over-payment as it is a variable amount and prone to delays due to processing via the IRD.

So as a strategy for low-income earners it's not that helpful, as most banks still want me to commit to the regular amount from a regular income source.

If I want to overpay my mortgage wouldn't I be better going on a contributions holiday and having the entirety of my 4 per cent available to me?

Answer:

No - to the tune of many thousands of dollars at retirement. What you are overlooking are the effects of KiwiSaver government and employer contributions.

But let's start at the beginning. Before KiwiSaver, the best use of your savings would generally be to pay extra off your mortgage.

If your mortgage interest rate was 10 per cent, repaying it faster than necessary improved your wealth as much as an investment that pays a 10 per cent return, after fees and taxes, and with no risk. No investment was that good.

But along came KiwiSaver. If you join and contribute $160 a month or $1920 a year, the government will contribute the maximum tax credit of $1043 a year. What's more, your employer will contribute at least 1 per cent of your pay, or $480 a year.

The total going into your account is $3443 - close to doubling your own contribution. And by the time the employer contribution reaches 4 per cent of pay, from April 2011, the total will be $4883 - more than 2.5 times your contribution.

That's powerful stuff. It means your retirement savings will be more than 2.5 times what you would have saved in a similar account outside KiwiSaver.

Calculations show that you are highly likely to end up better off at retirement than if you had put 4 per cent of your pay into extra mortgage repayments.

This is particularly true if you are within 20 or 25 years of retirement and you invest in a riskier KiwiSaver fund, with higher average returns.

In some market conditions, younger people in lower risk funds may be better off contributing to KiwiSaver for just a year and then taking a contributions holiday and putting the money into mortgage repayment. I would hope, though, that as New Zealanders become more familiar with KiwiSaver, long-term investors will move to higher risk funds anyway.

In any case, this all becomes academic once we add mortgage diversion to the mix. Almost all KiwiSaver employees with mortgages would be foolish not to use diversion.

With mortgage diversion, you put in only half the money, but you still get the KiwiSaver incentives. Employer contributions are unchanged, and - if you earn more than $52,150 a year - the tax credit is also unchanged.

If you earn less than that and divert half your contributions, the tax credit is smaller. That's because you'll leave less than $1043 in your account, and the tax credit matches your contribution up to $1043.

Even so, calculations show that every mortgaged employee should benefit from using mortgage diversion unless they earn under $26,075 and are either:

* Aged 35 to 55 and in a fairly conservative KiwiSaver fund - but not if they are in a riskier fund.

* Over 55, regardless of their fund.

In your case, you would divert $80 a month to mortgage repayment. The other $80 a month or $960 a year would stay in KiwiSaver. The government tax credit would match that, and your employer would still put in $480 a year until April 2009, rising gradually to $1920 a year from April 2011 on.

By 2011, the total going into your account would be $3840 a year - four times your contribution, which quadruples your retirement savings. Wow!

The maths go like this, assuming you start mortgage diversion now:

If you took a contributions holiday - or never joined KiwiSaver - and put the full $160 a month into extra mortgage payments on a 10 per cent mortgage, that would improve your wealth by about $32,000 over 10 years or $197,300 over 25 years.

On the other hand, contributing to KiwiSaver, with mortgage diversion, you would pay $80 a month off the mortgage. That would improve your wealth by $16,000 over 10 years or $98,700 over 25 years.

Your other $80 a month would go into KiwiSaver, to which we add the government and employer contributions. In a fairly conservative KiwiSaver fund, with average annual returns of 4 per cent after fees and taxes, your account would grow to $39,700 in 10 years or $141,100 in 25 years.

In total, then, over 10 years in KiwiSaver with diversion your wealth would grow by $55,700 - compared with $32,000 out of KiwiSaver.

Over 25 years, your wealth in KiwiSaver with diversion would grow by $239,800 - compared with $197,300 out of KiwiSaver.

The KiwiSaver totals should be even higher if you invest in a riskier KiwiSaver fund. The numbers are pretty compelling.

Consider, too, that on a contributions holiday you might not have the discipline to put 4 per cent of your pay into mortgage repayment. I strongly recommend you continue your KiwiSaver contributions and use mortgage diversion, knowing that you can always go on a contributions holiday if you get in a financial bind. But try to resist that. You'll be glad at retirement.

By the way, mortgage diversion doesn't make sense for the self-employed or other non-employees with mortgages. They do best by simply contributing $20 a week, or $1,043 a year, to KiwiSaver and then putting any extra saving into mortgage repayment.

 

Mary Holm is the author of bestselling books on KiwiSaver and personal finance. She is also a highly praised seminar presenter. Her written advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following that advice.    

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