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The debt dilemma: pay or invest?

Whether you pay off a mortgage, invest, or do a combination, it’ll benefit you long term – as long as you remain disciplined.

If you have some extra cash to splash, because your company paid out a generous bonus, or you inherited a windfall from a relative who has passed, or had a couple of numbers right in the lotto draw, you might face a delicious dilemma. That is, if you are responsible enough to not blow it all on an overseas trip, or ludicrous shopping spree.

If you have an existing bond on your house, or even some form of shorter-term debt like a credit card or overdraft, you are probably faced with the decision on whether you should use the surplus funds to pay off – or at least, substantially pay down – that pile of debt you’ve accumulated, or whether it is more advantageous to put the money to work by putting it away towards your nest egg.

You don’t have to make that decision alone. A financial advisor has the tools available for you to make an informed choice. Between deciding whether to pay down debt or to invest, they will help you consider your best investment options, determine your tolerance towards investment risk, and help you manage your cash flow.

Note that not all debt is equal. The type of debt will make a huge difference.

Falling into credit is easy and expensive. Simple math would suggest that it better to settle high-interest debt before saving for retirement or adding to your emergency fund. Generally, if you’re paying more interest than you’re earning in interest, you’re losing money. If you pay your debt first and put no money in savings, the downside is that you’ll have nothing but your credit cards to fall back on if you have a financial emergency. You can count on some type of expense coming, and it’s usually when you least expect it. Using your credit cards to fund an emergency only makes it harder to pay off your debt.

You might need to adopt a blended approach and save some while you pay down some of your debt at the same time. As soon as your advisor makes you understand the pros and cons of either situation, you can better assess your own situation and see how to tweak your savings and debt payments to move your goals forward in each area.

When it comes to mortgage debt, the choice is clearer cut. The easiest way to save money is to reduce the amount of time it takes to pay off the principal. Paying your mortgage on your primary residence as soon as possible should be an important goal for any homeowner and investor – whether you’re halfway through the process, just starting out, or even just buying a home. However, some homeowners would rather place all their savings in an investment rather than pay their mortgage debt.

Their rationale is that the return on the invested amount can be greater than the guaranteed return you will get to pay off your mortgage. But in order to earn inflation-neutralising returns in an investment, risk must be taken, whereas as long as the interest rate is higher than inflation (as far as I know it has always been the case in South Africa) you will always beat inflation by decreasing your mortgage. If you have a mortgage bond at prime, by paying extra, you earn a 10.25% risk-free, tax-free, fee-free, inflation-beating and liquid return. In the following table the properties of the two options are compared: 

 

Mortgage

Investment in shares

Risk

Risk Free

Risky, especially over shorter periods

Tax

Tax free

Not tax free

Return

Guaranteed inflation-beating returns (provided interest rates stay higher than inflation)

With the added risk, you can expect better returns. Can beat inflation and beat mortgage interest rates over longer periods of time

Fees

No fees

There will be fees

Liquidity

Highly liquid

Liquid – can withdraw at any time

Whether you pay off the mortgage, invest the money, or do a combination of the two, there is no right or wrong answer. Depending on what you decide it will be to your advantage in the long run – as long as you remain disciplined. Being in a situation where you are not only aware of the benefits of paying off your home loan, but are also able to do so, means that you are really facing a very good problem.

I like to think of home equity as a ‘store of value’. When you pay down your mortgage, it’s like putting money in the bank (albeit money that’s harder to access). That equity can be tapped when needed. There is also that sense of relief that comes from being mortgage-free. You know that if things don’t go according to plan — you lose your job, the economy tanks, etc — at least you have a place to live.

For my ending statement, take note that upgrading to larger, more expensive homes when you have paid off one home, is not a good idea. People are sometimes under the impression that ‘keeping up with the Joneses’ in smarter neighbourhoods means that they now own a grander asset. It doesn’t. Although your home is classified as an asset on your balance sheet, a distinction must be made between an income-generating asset and an expense that consumes much of your monthly cash flow. When you regularly upgrade to a new home, you use more and more of your cash flow for mortgage payments and are therefore not creating wealth.

If you are not sure which investment is best suited to your needs, consult a qualified, experienced financial advisor. Details of our team and our solution are here: Brenthurst Wealth

ADVISOR PROFILE

Marise Smit

Brenthurst Wealth

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