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How to approach the choice between debt and investment

*This content is brought to you by Wealth Brenthurst

By Marise Smith*

Household debt in South Africa decreased to 35.40% of GDP in the second quarter of 2021, from 38.20% of GDP in the first quarter of 2021, according to the Bank for International Settlements. More good news from a report by Momentum Investments shows that the local savings rate has increased by almost 22%, from less than 15% of GDP in 2019 to more than 18% in June 2021.

Marise Smith

This may indicate that South Africans are reducing debt and are more willing to save or invest. Yet another report shows that many households are using nearly 75% of their monthly income to pay off debt. So how do you choose between settling your debts first or saving and investing?

Focusing only on settling debt first would be a mistake, but not all debt is created equal. It’s always important to start by reducing high-interest debt. According to the National Credit Regulator, the maximum interest rate on credit cards is 20.5% and the maximum interest rate on personal loans is 27.5%. It would be unlikely to achieve these high returns in an investment over the course of a year without taking irrationally high levels of risk, which means your cash flow would be better served by reducing and avoiding this high interest bearing debt.

Interest charges are generally lower for long-term debt, for example, a bond for a property. Although you’ll save the total interest paid over the entire period by increasing your monthly repayments, you might be more rewarded by investing those extra funds instead if you expect the returns to be higher than the interest charged on your bond.

The value of faster debt settlement:

Purchase of property

Property purchase price Term Interest rate To pay
R3,000,000 20 years 6.95% R300,000
Monthly repayment required Increase in actual payment per month Duration reduced to Interest saved
R20 852 R25,000 14.17 years old R752 655

Source: Ooba calculators

So you’ve avoided having to pay R752,655 in interest, and you now have the full R25,000 per month available for investment.

The (illustrative) value of now investing the R25,000 per month for the remaining 5.83 years of the original bond term, gives you an investment value of R1,881,787* at the end of the period . These are now discretionary funds available for actual use.

* Assumptions: 9% return per year, 0% annual increase in contributions

If you instead decide to maintain your monthly bond repayments at the required amount for the 20-year term and invest the additional funds available to you, the (illustrative) value of a regular investment/savings over 20 years* would be:

Monthly fee Term Total at end of period
R5,000 20 years R3 217 280

* Assumptions: 9% return per year, 0% annual increase in contributions

In other words, at the end of the 20 years, your principal property is now paid off and you have R3.2 million available in discretionary funds.

This rationale assumes that the return on the amount invested may be greater than the guaranteed return you will get to pay off your mortgage. But to get inflation neutralizing returns in an investment you have to take risk, whereas if the interest rate is higher than inflation (as far as I know that has always been the case in South Africa ), you will always beat inflation by lowering your mortgage . If you have a mortgage bond at the prime rate, paying extra earns you a 7.50% return risk-free, tax-free, fee-free, inflation-free, and cash. In the following table, the properties of the two options are compared:

Also remember that if you are only focused on paying off your debts and no money is going into savings or investment accounts, the downside is that there will be no no choice but to use credit cards or personal loans to fall back in times of financial emergency. . Life always presents unexpected expenses, having an emergency fund is an important part of an overall financial plan.

Beyond saving for emergencies, investing for longer-term goals absolutely must go hand-in-hand with settling high-interest debt.

All investment matters – whether it’s paying off debt or investing and saving – have different risks and rewards and a range of assumptions will impact the outcome. You are strongly advised to consult with a credentialed, qualified and experienced advisor to navigate the investment landscape suited to each investor’s personal circumstances and financial goals.

  • Marise Smit, CFP®, is a Financial Advisor at Brenthurst Wealth Pretoria. [email protected]

Wealth Brenthurst

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