Kill bond or invest?
If you hate having debt, paying off a home loan early to save on interest can easily become an obsession. But should you be pumping every spare cent into your bond at the expense of investing?
Ideally, you should compromise by paying a bit extra into your home loan while at the same time investing in other asset classes over the long term. If you must decide between putting extra cash in your bond or investing it, here's what you need to consider:
• The interest rate
What are you paying in interest on your home loan, and what could you be earning in interest from an investment?
If the interest rate on your home loan is more than 10%, paying extra into your bond gives you a guaranteed annual return of 10% or more, says Brendan Dunn, a certified financial planner at Verso Wealth. "Employees of the big four banks, however, receive prime less 2% on their home loans. In most cases, it makes sense for them to invest rather than put extra in their bond. A South African multi-asset income fund or one with more exposure to equities is likely to beat a return of 7.5% or 7.75% over time," he says.
Paying extra into your home loan will always save you interest, but investment returns are typically not guaranteed - markets or your fund manager can perform poorly. However, with enough exposure to equities over the long term, you should earn returns in excess of the interest rate.
• Saving tax
If you're paying income tax, especially at a rate of more than 35%, you should consider the tax saving if you contribute to a retirement fund. Any tax saving could then be injected into your home loan.
Gerrit Viljoen, a certified financial planner at Ultima, says if you are paying tax at a rate of more than 35% it makes sense to make use of the maximum tax deduction of 27.5% of your remuneration or taxable income, to a maximum of R350,000.
A person earning about R1,275,000 a year will be liable for income tax of about R425,723. If they make the maximum contribution to a retirement fund, the income tax reduces to R282,223, thus providing an income tax saving of R143,500.
"This saving can then be utilised to pay extra into the bond, gaining the huge effect of reducing the interest and paying off the bond far quicker."
In numbers: R200k+
The amount you could save over 20 years with just R300 a month in a unit trust or paying extra off on your home loan and then saving the repayments
The problem is that many people don't use the income tax savings to invest or reduce their bond, Viljoen says. Instead the savings disappear in their daily expenses.
Gielie de Swardt, the head of retail distribution at Sanlam Investments, says a retirement annuity (RA) offers several benefits other than a tax refund on annual contributions. "You pay no tax on interest, dividends or capital gains while you remain invested in an RA; you enjoy protection against creditors and protection against yourself because you can't touch the money until you're 55."
• Diversified investments
When you diversify your investment, you spread your risks. By putting all your money into your property you're putting all your eggs in one basket and banking on a good return on that property. Ideally, your investments should be spread across asset classes (equities, property, bonds and cash, both local and foreign).
"Different assets perform differently. It's difficult to predict what will perform well at any given time. For this reason, we recommend having different assets in a portfolio. Over time each will add value to the portfolio," says Dunn.
South African residential property is linked to the local housing market and economy. Having investments in other assets, across other economies and in other currencies, will mean that your portfolio should continue to move forward even when the South African economy is struggling.
• Time horizon
When investing, time is your friend. As the adage goes, it's not timing the market that will make you rich, it's time in the market.
Many people think it's best to start investing only once they've paid off their home loan.
But over time, your bond repayment is eroded by inflation. So by the time you're bond-free, the amount you free up from paying your bond instalment won't be worth what it's worth today and you will have missed out on the magic of compounding, which you need to have working for you, especially when saving for retirement.
It's also easier to pay off your bond aggressively when you're further into your career and hopefully earning more and your instalment has been eroded by inflation.
Your time horizon is the time you have to invest. If you're in your 40s and you've only just bought your property, you can't afford to start investing for retirement only after you've paid off your bond 20 years later. But if you're 30, you have a longer time horizon, and you could afford to aggressively pay down your bond in, say, 10 years and then put what you would have spent on your repayments into your investments.
Parking extra money in your home loan is attractive because it's liquid. You can access any surplus funds easily if you have an access facility on your bond. But an investment in a unit trust or exchange-traded fund is also easily accessible.
An investment in an RA, while offering excellent tax benefits, is, however, not liquid unless you are over the age of 55, says Craig Gradidge, certified financial planner and executive director at Gradidge Mahura Investments. "You need to ensure there's enough liquidity in your balance sheet after topping up your RA. Typically, we advise you to have 20% to 30% of your balance sheet invested in assets with good liquidity."
• Emergency fund
If you're saving extra into your home loan you can count on those extra savings as an emergency funds provided your home loan has an access facility.
According to the Old Mutual Savings & Investment Monitor, only 30% of South Africans save for a rainy day, but Dunn says emergency savings make a massive difference to keeping your personal finances afloat.
What an extra R300 could do for you
If you had R300 a month to invest or to top up your home loan instalments, what is the better option and why?
Brendan Dunn, a certified financial planner at Verso Wealth, says paying an extra R300 a month into a mortgage bond of R1 million with a 20-year term (240 months) at the prime (9.75%) interest rate will reduce the repayment period by 20 months to 220 months.
After 220 months, you will have a paid-off property and can then invest R9,785 a month (R9,485 bond repayment + R300) for the remaining 20 months.
The net result after 20 years is a paid-off property and R213,287 in investments. This is assuming a 9.75% return over 20 years. (A return of 3% to 4% above inflation is the projection for a medium to high equity portfolio.)
Assuming you invested R300 a month into a high equity unit trust that returns 9.75% a year net of all fees for 20 years, you will have R222,353 and a paid-off property.
With these assumptions, it appears better to invest from day one, but different returns and interest rates can result in a different outcome.