Pay off bond or Invest?

Information sourced from Stealthy Wealth. 

Pay Off Bond Or Invest? The idea of being bond free sounds great but does it come at an unforeseen opportunity cost? Paying off debt is always a good idea and the advantages of paying extra into your bond are:

  1. It is risk free - the money you put in cannot be wiped out  
  2. It is tax free - one of the few things in life that is!
  3. It is inflation bearing- as long as the interest rate is above inflation (as far as I know this has always been the case in South Africa)
  4. Low cost - there are no extra fees involved (your bond fee is charged regardless)

But the question remains - what is the alternative? Here are some pointers written by Alexander Forbes. 

1) Primary residence or investment property?
The first consideration (before we touch on the investment return versus interest debate) is the purpose of the property. Is this the property you live in, or is it an investment from which you hope to receive capital growth and rental income?

The major and obvious difference between the two is that you are either paying off the bond yourself or you have an investment assisting in paying that bond. If the property in question is for investment purposes, it is often wise to leave just enough debt in the bond so that your monthly rental income (less levies, rates and taxes) will cover the monthly bond instalments.

This is what is known as financial ‘leverage’, or more simply put, making investment returns from borrowed money. Further to this, the interest from the bond is considered as a tax deduction.

2) Investment return versus interest
This really makes up the essence of this debate. The bottom line is the interest that is paid on your bond is a certainty, the return on any long-term investment is not. There are very few investments that give returns above a guaranteed 9.25% per year (the current prime interest rate, which is expected to increase) – even those that do, will be volatile in nature and will need a significant long-term buy in, with no guarantees. In saying that, you simply need to look at the returns of the JSE All Share Index for the past five years  to see an average return of 16.8% – a considerably higher return than the interest rate on a bond.

Such investments, however, are certainly not guaranteed and you would need a significant amount of discipline to not access the money in means of poor or negative performance.

3) Tax considerations.
For any long-term investment product, one needs to be aware of capital gains tax (up to 13.33% of any capital growth on the sale of an asset), dividends withholding tax and, potentially, interest tax. There are tax-deductible investments, with tax-free growth, such as retirement annuities (which are potentially taxed aer recruitment through retirement tax or income tax) as well as the newly legislated tax-free savings accounts, which have zero tax at all. These all give weight to the argument towards the efficiency of saving your cash instead of pumping it into the bond, but the same potential investment risk still applies.

4) Is the bond accessible?
If your bond doesn’t allow access to the money in times of an emergency, it is recommended that, before you even think of plowing excess cash into it, you build a contingency fund of sorts. Try to put aside at least three months or more of what you spend on living expenses for unexpected times of need. This should be kept in a flexible account that is available on short notice. On the other hand, some bonds allow you to withdraw as much as six times per year. This means that, even if you don’t need to access the cash, you’re still providing yourself with a guaranteed interest savings, which will likely be superior to what you would get in a savings account.

5) Interest rate considerations
It’s very important to consider the variability of your interest rate when deciding to accelerate paying off your bond. Naturally, when interest rates are high, bonds may seem more and more unaffordable and may attract most of your attention as a financial priority. Of course, maintaining your bond payments at this stage is a priority. When interest rates are low, this is often the time in which people dip into their bond for ‘cheap’ financing, as would seem logical to most. However, this is often the best time to pay off the interest on your bond more quickly and really allow yourself to save in the long term.

Finally, there are many elements you can’t really measure, such as the peace of mind of having debt paid off, or the knowledge of owning a physical, tangible asset. At the end of the day, it comes down to an individual’s personal circumstance. As long as you’re putting the money into an investment that is either saving you money or giving you inflation bearing returns, you aren’t too far off the mark, regardless of which way you decide to go.

Lets take a look at a hypothetical example by comparing placing additional monies into a bond versus into a discretionary investment:

First off, some assumptions:

Purchase Price

  • R1 000 000 Deposit
  • 10% Interest on Loan
  • 10.5% (current prime interest rate) Equity Returns
  • 15.28 So in this scenario your monthly payment is R8 985. 

Paying the minimum will result in paying off the house at the end of the 20 years. However you did not find the most expensive house, but bought one that suited your needs. Secondly, you tend to spend less than other people. All this results in being able to put some extra money into the bond every month .

Lets look at a 20 year scenario, since that is the base case and general duraon of a home loan when nothing extra is added.

Scenario 1 - Extra R2 000
According to your budget, you have an extra R2 000 a month. You decide that you will either pay this extra R2 000 into your bond, or you will invest it in equities instead.

Option A) Extra R2 000 into the bond:

  • This means that your house is now paid off in around 12 years.
  • After that you have an extra R10 985/month to invest as there are no more bond payments and there is no need to put the R2 000 extra in every month.
  • So for the remainder of the 20 year period, you invest the full R10 985 into equities.

Taking this option means that after 20 years you get:

  1. A paid-off house
  2. A nice nest egg of R1.919 million

Option B) Invest the R2 000

You pay the minimum into your bond, and your house is paid off aer 20 years, you invest R2000 per month into equities every month for 20 years

Taking this opon means that after 20 years you get:

  1. A paid off house
  2. A nicer nest egg of R2.715 million

Option B seems to be the better choice by around R800k.

Scenario 2 - Extra R6 000 

Option A) Extra R6 000 into Bond:

  • This means that your house is now paid off in just over 7 years.
  • After that you have an extra R14 985/month to invest as there are no more bond payments and there is no need to put the R6 000 extra in every month.
  •  So for the remainder of the 20 year period, you invest the full R14 985 into equities.

Taking this opon means that aer 20 years you get:

  1. A paid off house
  2. A nice nest egg of R6.539 million

Option B) Invest the R6 000

  • You pay the minimum into your bond, and your house is paid off after 20 years
  • You invest R6 000 per month every month for 20 years 

Taking this opon means that after 20 years you get:

  1. A paid off house
  2. A very nice nest egg of R8.077 million

So once again , Option B seems like the better choice. Investing the money is the better choice, or is it? In both the scenario's above it seemed obvious that investing any extra money into equities is more rewarding than putting it into your bond. But unfortunately there is more to it...

 

From the chart you can see that on shorter time frames, for example over 5 years, the returns from the equity market can vary drastically - in this case from 46.19%  to a mere 0.57%. However if you start looking over longer periods, the returns become a lot more "predictable" - the 15 years numbers are significantly better. But as always, the past returns are no guarantee of future performance.

  • If the extra repayment into a bond is going to result in you decreasing the loan time to around 15 years, then you should maybe consider putting the extra money into a low cost Equity ETF instead - because there is a good chance the returns from equities will outperform the interest rate of the bond.
     
  • If the extra repayment is going to result in you paying off your bond in 10 years or less, then maybe the safer opon would be to squash your bond because the equity returns are somewhat less reliable and more risky. Of course any combination of the two is definitely an opon as well. Why not get the benefits of both by Investing some of the extra money into equities and putting the rest into the bond?

A last word on interest rates and tax
The above scenarios used an interest rate of 10.5%. The scenarios also assumed equities would return 15.28%. This difference between the equity returns and the interest rate is what makes the investment into equity option come out on top in both scenarios.

An important consideration is therefore the current interest rate. If this rate goes up then it certainly starts bending preferences back towards the guaranteed returns of the bond. Likewise if the interest rate drops then the equity investment scenario becomes even more favourable. So it is important not to get too fixated one method and completely forget about the other. Be prepared to be flexible and adapt as the economic climate changes.

Always remember that the bond returns are tax free! However now that we have TFSA's your investment could also be tax free. In the scenario's above any tax implications of selling the investment at the end of the 20 year period was not considered. If you did not invest the extra funds into a TFSA and you were to sell, you could incur a capital gains tax (keeping in mind there would be tax implications for the selling of both Opon A and Option B).

In conclusion all this can be summarized nicely into a table showing the characterisations of the two options:

Another important take away from all this is that whether you go one way or the other, or a blend of the two, there is no right or wrong answer and whatever you end up deciding will leave you better off in the long run - provided you are disciplined! Being in a situaon where you are not only aware of the benefits of paying off your home loan quicker, but also in a posion to do so, and faced with the dilemma of whether to invest the money instead, means you are actually facing a very nice nest egg.