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SETTLING DEBT VERSUS PARTICIPATING IN THE MARKETS

by | Sep 1, 2021

Arguably one of the most common questions in investors mind, and understandable so. On one hand many financial experts constantly endorse the recommendation of staying clear of debt, and on the other hand the saying “time in the markets, beats timing the market” is repetitively recapped.

Before the various options are discussed, it is imperative to be aware of the opportunity costs that you may forgo when transferring all available resources into your bond.

Let’s firstly look at the pros and cons of paying off your debt vs investing:

Pros                                                                            Cons
Paying debt quicker reduces the interest charges Less liquidity, as contributions are focused on paying off debt
Settling your debt earlier, can allow for the repayment allocation to be redirected to an investment sooner. Tax benefits of investing in specific investment products.
If you have an access bond, this may provide liquidity or act as an emergency fund. “Time in the markets, beats timing the markets” – age old saying.

Next, it is pivotal to understand whether the investment returns are favorable from participating in the market versus the interest rate charged by the lender.

Like all investment questions, the answers are best depicted in an illustrated example. Let’s look at Theo’s situation.

Name: Theo Mapati
Age: 35
Gross Salary: 60,000 pm
Marginal Tax Rate: 39%
Debt: R850,000
Current repayment: R8,000
Available cash: R17,000
Interest Rate on loan: 7% per annum

Recommended Investment Products & Portfolio:

  • Retirement Annuity: RWM Growth Portfolio – 9%
  • TFSA: RWM Tax Free Portfolio – 15%
  • Unit Trust: RWM Worldwide Portfolio – 12%

Based on the example with Theo, he has an additional R17,000 available and would like to know what the most suitable decision would be. There are three possible strategies, using the assumptions indicated earlier.

Option 1: Use the additional available cash of R17,000 and try pay off the debt as soon as possible. Once paid off, follow the recommend investment strategy, and invest the following in each product:

  • Retirement Annuity: R9,000
  • TFSA: R3,000
  • Unit Trust: R13,000

Option 2: Continue paying the current debt repayment and invest the available cash. Follow the same recommendation, except with the following amounts:

  • Retirement Annuity: R9,000
  • TFSA: R3,000
  • Unit Trust: R5,000

Figure 2 nicely illustrates the capital projection of the two different options. As you will notice it will be greatly more beneficial for Theo to participate in the market, then to rather try settle his debt in a shorter time. Therefore, based on the example of Theo, option 1 will be more suitable.

There are a several benefits when investing in different products, rather than just investing in one. Within a retirement annuity your contributions are tax deductible to a maximum of 27.5%, this means that you can pay less tax and investment growth returns are tax free. While investing in a unit trust may not offer the same tax advantages as a retirement annuity, there is no restrictions on asset class exposure or flexibility.

 

Please note that the information provided below does not constitute financial advice; in fact, we are precluded from giving specific advice. Generic information has been provided given the context of an illustrated example. We have limited details about you and your circumstances, and such detail may impact any advice provided.