An avid Zonotho reader recently asked a question that got us excited about writing this article. Philani asked if it wouldn’t be better to put any extra cash in investments instead of using it to pay off your bond. This was after reading Save yourself 10 years of bond payments. Riveting!
Now we all know the benefits of putting extra money towards your bond. You get to pay off your bond faster, pay less interest and avoid the danger of failing to make payments in the future. Similarly, the benefits of having different investments are well known. Returns on shares and other investments can be very high – allowing you to accumulate wealth for future generations. These points, as valid as they are, can be subjective. In true Zonotho fashion, we ran a very simple model to answer this question in an unbiased manner. The results were fascinating!
Consider a situation where you and your colleague got R70,000 bonus from your employer. Invest in shares? or pay into your bond?
Imagine that you both have a home loan with an outstanding term of 20 years and monthly payments of R6,980. The interest on both home loans is a fixed 11% per year and there are no other costs. Upon receiving the bonus, you decide to invest the full amount in shares. Your colleague -on the other hand- decides to use all the cash to pay into her bond. Both of you continue to pay R6,980 into your bonds.
The effect of the two different decisions is
- You get to earn share investment returns from day one. But only pay off your bond in 20 years
- Your colleague would able to finish paying her bond in 14 years and 11 months. This saves her R420,000 worth of future payments. Finishing the bond early allows her to then invest the R420,000 that she saved in shares.
Saving R420,000 by paying in R70,000 is quite impressive.
The verdict on who made the better decision, however, depends on how the investment market performs.
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If the total return in the investment markets (NB: after fees and tax) is higher than the 11% bond interest rate, then you would be better off at the end of 20 years.
Say the investment in shares performed at a buoyant 15% pa net of fees and tax, your R70,000 would grow to R1,15m in 20 years. Your colleague, on the other hand, would end up with just over R622,000 after investing her future savings. The share market investment would beat paying off your bond in this case.
If, the investment market performed at say 7%, you would end up with about R270,000 in 20 years, while your colleague ends up with R511,000. Paying off your bond faster worked out better in this situation.
Clearly, from the above – the verdict depends on the performance of investment markets relative to the bond borrowing rate.
If the return that you earn on the investment is more than the bond interest rate then you are better off. Otherwise, if the return on your investment is less than the interest rate on your bond then you are worse off.
The challenge is that we can never know how investment markets will perform in the future. You would also need to account for the method you use to invest since tax and fees would impact your return. Additionally, how the prime rate will change over-time would in reality affect your bond repayments.
A good compromise might be to use part of your bonus to pay off the bond and invest the rest. This is in contrast to putting all your eggs in one basket- a concept known as diversification.