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By Marise Smit* 

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. Other good news from a report by Momentum Investments shows that the local savings rate increased by nearly 22%, from less than 15% of GDP in 2019 to more than 18% in June 2021.

Marise Smit

This may indicate that South Africans are reducing their debt burden and are more committed to saving or investing. Yet, another report shows that many households use almost 75% of their monthly income to pay off debt. So, how to choose between settling debt first or saving and investing?

Only focusing on settling debt first would be a mistake, but not all debt is equal. It is always important to reduce high interest-bearing debt first. 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 on irrational high levels of risk, which means that your cashflow would be better served by reducing and avoiding this high interest-bearing debt.

Interest rate charges are typically lower for long term debt, e.g., a bond for a property. Although you do save in total interest paid over the full period by increasing your monthly repayments, you may be rewarded more by rather investing these extra funds if you expect returns to be greater than the interest being charged on your bond.

The value of settling debt faster:

Property purchase

Property purchase price Term Interest rate Deposit
R3 000 000 20 years 6.95% R300 000
Monthly repayment required Increased actual payment per month Term reduced to Interest saved
R20 852 R25 000 14.17 years R752 655

Source: Ooba Calculators

Thus, you have saved having to pay R752 655 in interest, and now you 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. This is now discretionary funds available for actual use.

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

If you rather decide to keep your monthly bond repayments to the required amount for the 20-year term, and invest the extra funds you have available the (illustrative) value of regular investing/saving over 20 years* would be:

Monthly contribution Term Total at end of the period
R5 000 20 years R3 217 280

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

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

This rationale assumes that the return on the invested amount can be greater than the guaranteed return you will get to pay off your mortgage. But to earn inflation-neutralising returns in an investment, risk must be taken, whereas if 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 7.50% risk-free, tax-free, fee-free, inflation-beating, and liquid return. In the following table the properties of the two options are compared:

Also remember, if you only focus on paying off debt first and no money is paid into savings or investment accounts, the downside is that there will be no other option but using credit cards or personal loans to fall back on in case of a financial emergency. Life always presents unexpected expenses, having an emergency fund is an important component of an overall financial plan.

Beyond saving for emergencies, investing for longer-term goals absolutely must run concurrently with settling high interest-bearing debt.

All investment issues – whether paying debt or investing and saving – present different risks and benefits and a range of assumptions will have an impact on the outcome. It is highly advisable to consult an accredited, qualified, experienced advisor to navigate the investment landscape suited to each investor’s personal circumstances and financial goals.