Managing financial windfalls: should you pay off your debt?

Being in debt has both a financial and psychological impact. Some people worry so much about being in debt that they avoid it all together. They might use every penny they have to pay off debt as soon as it appears. However, from a purely financial point of view, keeping or paying off debt is a question of return on capital.

You need to look at the net cost of keeping that debt, i.e. after factoring in the tax shield it creates. Once you have that amount, compare it with the net return – after you deduct costs and tax – on your wealth. If your net return exceeds the net cost of the debt, it’s in your interests to keep the debt. However, if your net return is lower than the net cost, you’ll save money by paying off the debt.

Remember to think ahead and assess your future situation in terms of the expected return and how it’s taxed. You’ll also need to think about the interest on your debt and to what extent it’s tax-deductible on your income tax return.

To calculate the net return on your wealth from savings and investment (box 3), you’ll also need to factor in how this wealth is taxed. In 2024, savings and investments (box 3) are taxed at a rate of 36%. From 2027, this tax will be levied on the actual (rather than the assumed) return, and then only on the amount above your tax-free allowance. In that case, assuming that the tax rate remains the same, you would keep 64% of the return after tax.

Unless something changes, the current ‘Box 3 Bridging Act’ (Overbruggingswet box 3) applies until 2027. Under this law, the value of your wealth is taxed according to a flat, assumed rate of return, based on your wealth on 1 January (the reference date) of the tax year in question. Each taxpayer has a tax-free allowance of €57,000 in savings and investments (tax partners have a joint allowance of €114,000). Wealth from savings and investments is divided into three categories: ‘bank balances’, ‘investments and other assets’ and ‘debts’. Each category is subject to its own rate of return. The rate for ‘investments and other assets’ is calculated in advance each year according to a past long-term average. In 2024, it is 6.04%. However, this rate can differ significantly from actual returns. A tax rate of 36% means the tax amounts to about 2.17% of wealth (36% x 6.04%).

The assumed interest on ‘bank balances’ and ‘debts’ is calculated retrospectively each year. For ‘bank balances’, the interest rate is determined on the basis of the average interest rate on short-term fixed deposits as published by the Dutch central bank. As a result, the assumed savings interest rate on ‘bank balances’ more accurately reflects the going rates on savings accounts. In 2023, the assumed savings interest rate was 0.92%. If the 2024 average were 1.5%, the effective tax rate would be 0.54% (36% x 1.5%).

To calculate the net cost of debt, you offset the interest you pay on the debt against the tax shield created by the debt. The cost of debt depends on whether the debt comes under box 1 (income from work and home ownership) or box 3 (income from savings and investments).

If you’re a homeowner, you must add a specific percentage of your home’s ‘WOZ value’ (the annual valuation of your home by your local municipality) to your income from work and home ownership (box 1). This is known as the ‘eigenwoningforfait’. A rate of 0.35% applies to homes with a ‘WOZ value’ up to €1,310,000. Homes with a ‘WOZ value’ above this amount are subject to a 2.35% rate (2024 rate). Your other income in box 1 determines your income tax band, with the highest being 49.5%. In 2024, taxpayers with box 1 income above €75,518 came under this tax band.

Under certain conditions, you may deduct the interest you pay on the mortgage of your home in box 1 from your box 1 income. Your maximum tax shield amounts to about 37%, with the net cost of the debt equal to about 63% of the interest paid. This calculation assumes you make only limited repayments on your mortgage and the interest on the outstanding debt is still higher than the amount of additional tax you owe on taxable income from your main residence (‘eigenwoningforfait’).

Example 1A

Charlotte owns a home with a ‘WOZ value’ of €400,000 and has a mortgage debt of €300,000 at a 4% interest rate. She has €70,000 in income from work and home ownership (box 1) and an investment portfolio worth €500,000. Charlotte is considering paying off an extra €50,000 on her mortgage. The tax rate on taxable income from her main residence (‘eigenwoningforfait’) is 0.35% of €400,000, so she owes €1,400. The interest she pays on her outstanding mortgage debt is €12,000 (4% x €300,000). After making the repayment of €50,000, she pays €10,000 in interest (4% x €250,000). The net cost of the outstanding debt amounts to 2.52% (63% x 4%). In this case, repaying her mortgage works to her advantage if the net return after tax on her wealth in box 3 (savings and investment) is lower than 2.52%. Assuming that her wealth is taxed according to the assumed-return system, repaying works to her advantage if the return from her wealth (‘investments and other assets’) is lower than approximately 4.69%. This is because she’s left with 2.52% net after deducting 2.17% tax (2024 rate). If we assume a tax rate of 36% on the actual return, Charlotte can save money by repaying her mortgage if the return is below approximately 3.94%. Again, she’s left with around 2.52% net after deducting 36% tax.

The calculation becomes a bit more complex if you pay off all or almost all of your mortgage. Under the ‘Hillen deduction’ rule, you pay less tax on your taxable income from your main residence (‘eigenwoningforfait’). You should factor this into your calculations if you want to produce an accurate comparison. After you’ve paid off your mortgage, you only pay income tax on 20% of the additional taxable income from your main residence in 2024. It’s worth noting that the ‘Hillen deduction’ will be decreased by 3.33% each year over 30 years, starting in 2019.

Example 1B

Charlotte from example 1A is wondering whether she could save money by paying off her mortgage debt in full. After paying off her mortgage, she no longer pays any interest on the debt. The net cost of the interest she no longer has to pay amounts to 2.52% (approximately 63% x 4%). In this case, she again saves about 37% of 80% of the tax on taxable income from her main residence of €1,400 on her 2024 income tax return, which in this case amounts to €414. That saving equals about 0.1% of her mortgage debts of €400,000. The total net cost she saves by repaying amounts to around 2.65%. As long as the net return after tax on her wealth is higher than about 2.65%, keeping that debt works to her advantage. If her wealth is taxed according to the assumed-return system, repaying can work to her advantage if the return from her wealth (‘investments and other assets’) is less than approximately 4.82% (2.65% + 2.17%). If we assume a tax rate of 36% on the actual return, Charlotte could save money by repaying her mortgage if the return is below approximately 4.14% (2.65% ÷ 64%).

If the debt came under box 3 (savings and investment) and the tax were levied on the actual rate of return on the wealth, the tax savings from keeping the debt would again amount to 36% of the interest owed. This makes the calculation very simple. Paying off the debt is cost-effective if the return on savings and investments is lower than the interest on your debt.

Under the assumed-rate tax system, the tax shield created by the debt depends on the assumed rate applicable at the time. In 2023, this rate was 2.46%. Imagine that the average rate for 2024 is 2.50%. If we discount your personal allowance, your effective savings are 0.90% (36% x 2.50%). In contrast, the tax on the wealth that you can use to pay off the debt is 2.17% (‘assets and investments’) in 2024. This creates ‘tax leakage’ of 2.17% – 0.90% = 1.27%. Unless the return on your wealth is at least 1.27% higher than the interest you pay on the debt, paying off the debt works to your advantage. It’s worth noting that debt in box 3 (savings and investments) is only taken into account in so far as the total is above the ‘debt threshold’ (€3,700 per person in 2024).

Example 2

If the debt came under box 3 (savings and investment) and the tax were levied on the actual rate of return on the wealth, the tax savings from keeping the debt would again amount to 36% of the interest owed. This makes the calculation very simple. Paying off the debt is cost-effective if the return on savings and investments is lower than the interest on your debt.

Under the assumed-rate tax system, the tax shield created by the debt depends on the assumed rate applicable at the time. In 2023, this rate was 2.46%. Imagine that the average rate for 2024 is 2.50%. If we discount your personal allowance, your effective savings are 0.90% (36% x 2.50%). In contrast, the tax on the wealth that you can use to pay off the debt is 2.17% (‘assets and investments’) in 2024. This creates ‘tax leakage’ of 2.17% – 0.90% = 1.27%. Unless the return on your wealth is at least 1.27% higher than the interest you pay on the debt, paying off the debt works to your advantage. It’s worth noting that debt in box 3 (savings and investments) is only taken into account in so far as the total is above the ‘debt threshold’ (€3,700 per person in 2024).

If you pay debt off before the end of the contractual interest rate term, your bank may charge you an early repayment fee. You’re most at risk of incurring this fee if the interest on the loan you want to pay off is higher than the interest the bank can earn by reloaning the repaid amount for the rest of the loan’s term. You can usually repay a certain percentage of the original loan amount without incurring an early repayment fee. If you want to repay more, the fee will be levied on the excess amount. The early repayment fee for repaying the mortgage on your main residence (box 1) is tax-deductible in box 1. The lower the return on your wealth, the shorter the ‘payback period’ of the net early repayment fee after tax. You’re therefore better off reducing the debt.

If you have an endowment mortgage, the choice whether or not to pay off your mortgage isn’t as clear-cut. This is because the mortgage is linked to a locked-in account or insurer’s endowment policy. You pay monthly deposits or contributions to build up a tax-free sum to pay off the mortgage when it matures. In many cases, terminating an endowment mortgage won’t leave you better off. A mortgage adviser can do the calculations for you.

You also need to carefully consider the fact that repaying the mortgage on your main residence ‘locks’ your money into bricks and mortar. It’s not always easy to release that cash in the future without first selling your home. And if you take out another loan in the meantime, that loan will normally be in box 3 (savings and investment). As long as your wealth in box 3 is taxed under the assumed-rate system, which is the same for every taxpayer, tax relief on a loan in box 3 can differ significantly from tax relief on a loan in box 1. The difference is minor if the real-rate system is applied to the return and costs, supposing that the rates against which you can deduct the interest in box 1 (around 37%) or box 3 (36%) continue to be more or less the same.

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