Kill debt or invest? – Moneyweb

This debate has continued since people could finance items and invest their hard-earned cash. I will weigh the different options to provide some guidelines and hopefully generate some information that can assist investors in deciding whether to invest or eliminate debt.

When comparing anything involving figures and math, the outcome always depends on the assumptions used. The financial services industry and advisors are very skilled at manipulating figures. I can prove any outcome I wish by using favourable numbers and assumptions, so whatever I disclose or “prove” can be (and probably will be) challenged. I will, however, try my best not to be biased.

First, a few facts to consider:

• If you borrow money for a purpose, the amount you repay increases with a longer repayment term, even if the interest rate remains the same across different periods (some may argue that this is logical). You might be surprised at how many people do not understand this. Therefore, it stands to reason to either reduce the term of your debt or kill it as quickly as possible. But there is a caveat.
• There is a distinct difference between good debt and bad debt. 
• “General debt” usually has a higher interest rate than “asset debt”. This means that the interest rate on your house is likely lower than that of your car, credit card, overdraft, and clothing account debt. 

In principle, always apply the following:

• Where debt or loan interest rates are higher than the prime rate, start looking at ways to reduce that debt. Banks generally charge an interest rate linked to the prime lending rate. Clients with good credit records can rely on “prime minus” rates, while clients who are new to borrowing or who do not have unblemished records will probably end up with “prime plus” agreements. For those with “prime plus” agreements, work on either getting a better rate or reducing the debt term or debt amount as soon as possible.
• Invest with the best returns in mind, and borrow with the lowest interest rate in mind.
• If debt interest is obviously going to be higher than investment returns, kill the debt.
• In principle, you should kill bad debt and use good debt to your advantage. Effective gearing can enhance your wealth substantially, but that is a topic for another article.

Let’s get down to the actual purpose of this article. So, what is the best?

Should you pay off your bond or invest? The same principle applies whether you intend to use a lump sum or monthly contributions. I will use a scenario where someone receives an increase of R5 000 per month. Should they increase their bond repayment by R5 000 or start an investment of R5 000 monthly? Well, it depends …

For the sake of this article, I am going to assume the following:

• A bond of R 2 million with an interest rate of 11% (current prime lending rate);
• The bond term is 25 years, and the repayment is R19 602 per month, linked to a varying interest rate; and
• Client brief: Should I increase my bond payment to R24 602 or invest R5 000 monthly?

The deciding factor here is three-fold:

• What is greater, the bond interest rate or the potential returns?
• How dynamic must an investment be to make it worthwhile?
• In what cycle is the interest rate? Over the next two years, do you expect it to increase or decrease?

Sum time is fun time! Let’s crunch some numbers.

1. If the bond is increased by R5 000 per month, the repayment period will be reduced from 25 years to 12 and a half years, amounting to a savings of R2 194 683.
2. If R5 000 gets invested for 25 years and earns 11% per year, an investment amount of R7.9 million will be accumulated over the 25-year period.
3. If the bond repayment is increased by five years and settled in 12 and a half years, and the R24 602 is invested for the remaining 12 and a half years, R7.9 million will be accumulated.

• In the above scenario, the financial outcome is the same if 11% is used in the calculations. This is a pure coincidence and not the norm. 11% is the equilibrium in this example. See the table below for further illustrations.

Experience has taught us that when interest rates go up, markets and investments generally suffer and reduce in value. On the flip side, when interest rates reduce, then investments (bonds, equities, and property) tend to do well. This means that your decision will depend mainly on the interest rate cycle. Let’s take the above example and add some numbers.

If the repayment remains unchanged as per the loan agreement, a total of R5 881 000 would be repaid over the 25-year term if all the figures and assumptions remained static. I know this assumption is unrealistic, but bond rates can be fixed, in which case the figures would be accurate.

By investing surplus funds, the following capital will be accumulated.

Investment amount per month	Years	Return % per year	Final amount
5 000	25 years	11%	7.9 million
(total investment R 1 500 000)		12%	9.4 million
		13%	11.2 million
		10%	6.6 million
24 602	12.5 years	11%	7.9 million
(total investment R 3 690 300)		12%	8.5 million
		13%	9.2 million
		10%	7.3 million

From the above, we can conclude that if we are confident that returns will be good, investing a smaller amount for longer rather than investing much more aggressively for a shorter period will make sense. This is the perfect illustration of compound interest at work. When one considers the total amount invested versus the final outcome, it further indicates the benefit of early investing and the benefit of compounding returns. 

I have ignored volatility, which probably is not correct, but considering the terms of measurement, volatility should not be that much different given the duration of the investments. Of course, this can also work the other way around, where interest rates increase and investment returns disappoint, leaving you in a worse position. My conclusion is that the interest rate cycle will have to be monitored, and your strategy must be adapted to suit the prevailing trend.

When interest rates do trend upward, one can always withdraw some of the invested funds and reduce the bond loan value to improve cash flow and overall debt.

For instance, if you add R200 000 to your 25-year outstanding bond with an 11% interest rate, the bond term will be reduced by eight years and two months, with an overall saving of R1 920 651 if you keep the bond repayment the same. Alternatively, if the repayment period remains unchanged, the monthly premium will reduce from R19 602  to R17 642.

To elaborate on the above, one might also consider contributing to a retirement annuity (RA) or pension fund. For the aforementioned bond of R2 million, one would need an income in the region of R69 000 per month. Companies generally contribute 10% towards retirement funds (with a 50/50 split between the company and the member), which means the retirement fund contribution amounts to R6 900 per month in this scenario. The full R5 000 per month can then be allocated towards funding an RA, from which the investor will receive approximately R1 400 per month as a tax deduction. Investing the R1 400 over 25 years at a rate of 12% could yield an additional R2.6 million on top of the R9.4 million, assuming a consistent 12% return over the 25 years. The total sum of R11 million is significantly higher than all the other considerations mentioned above.

The essence of my story is that the process involves numerous variables that must be monitored and actively managed. Given such a long timeframe and many factors to consider, the perfect solution cannot be determined in advance.

Whenever I feel uncertain about the most suitable solution, I adopt the strategy of a fence-sitter. I will do that again and suggest that perhaps the best decision in the scenario above would be to allocate the funds on a 50/50 basis. Invest 50% monthly in your bond and 50% in investments. Every individual’s financial situation and aspirations are different. It makes sense to take all factors into account before identifying your ideal solution.

Health warning: Avoid investing all your surplus funds into your bond. Far too often, I encounter investors who have a fantastic home but insufficient retirement funding. Don’t assume that you will be able to sell your property at a massive profit when you retire and use the proceeds to retire. This goes wrong far too often … This sounds like a good theme for a future article.

Invest wisely and think outside the box.