To kill a bond or not?

I regularly come across clients and friends with a willingness to pay off their bond on a primary residence as quickly as possible.

The motivation to do this is generally twofold. The first driver is to be debt-free, and the second is to free up cashflow. Given my background I see the decision to pay off a bond over the term, or sooner, as an investment decision hinging on how best to use the available ‘spend’ to create long-term wealth. I do get the point about the rate on your bond being a guaranteed return, but a house is only a productive asset if you sell it one day and buy something for less; it will be an asset on your death for the beneficiary of the house.

Before I get into the guts of my article, I will share a personal view on a primary-residence bond; I am not in any rush to pay off my bond:

• I am paying off a debt based on my purchase price. The property value should go up over time, so I get to pay off debt based on the original purchase price, however the value is going up (very different to a car).
• The monthly payment, due to inflation, goes down every year. In ten years, the real present value of a R10 000 pm payment at 6% inflation is R5 583.95. Given this, if you get an annual salary increase, the repayments should become more affordable each year and you may have spare cash.

The only way to test the theory that it’s better to pay off a bond early, is to make some assumptions and calculations. Assume that you can afford to make your monthly bond payment plus an additional 20%. The decision, and the crux of this analysis, is whether you should invest the additional 20% into your bond or rather allocate this to investments. I have used the following parameters to test the outcomes:

• R3 million bond with instalments payable at the current prime rate (10.25%), over the term
• 20-year repayment is R29 449 per month
• R29 449 plus 20% is R5 890
• Start at age 30 and then retire and stop saving at age 65 (35-year term)
• When you finish paying off the bond, you will save whatever you were paying towards the bond.

If you decide to pay off the bond over the term, you can save R5 890 [per month] for the first 20 years and then R35 339 (R29 449 + R5 890) [per month] for the remaining 15 years. If you decide to pay off the bond quicker – by contributing an additional 20% – it will take you 152 months to pay off the bond and you will then have 268 months (22.3 years) to save R35 339 per month.

Before we discuss the outcome, the next table assumes you allocate 50% of your savings to a retirement annuity (RA), have a 30% average tax rate, and that you reinvest the tax you get back from the tax-deductible RA contribution:

The simple, and logical, conclusion is that if you can get an investment return higher than the interest rate on your bond then you should allocate any additional cash you have to investments. We cannot predict investment returns but theoretically you should get a long-term return of around inflation +5% for an equity-centric investment.

My view is that by starting to save early it becomes habitual and you can start seeing the benefit of any accumulating value earlier on, than if you wait until your bond is paid off. A second advantage is that if you have any emergency that requires cash you have an investment(s) that you can tap into (although an RA is illiquid); one could correctly argue that an access bond serves the same purpose.

The second conclusion is that the tax deduction on an RA is powerful if you reinvest the tax you get back from the deduction. You don’t want to put everything into an RA, as it is illiquid – you cannot access any of the money until you reach retirement age (minimum age 55) and thereafter you can only withdraw up to 1/3 in cash. Beyond the tax deduction, an RA has some other great benefits:

• The asset is protected from creditors;
• There’s no estate duty;
• Growth within the RA is tax free;
• There are no executor fees.

A complimentary investment to an RA is a tax-free savings account (TFSA) where you can contribute up to R33 000 per annum or R2 750 per month. Like an RA, all growth in a TFSA is tax free.

The supporters of paying off your bond as quickly as you can point out that the interest on your bond is a tax-free return. As such, it makes sense to use an RA and a TFSA as your first savings vehicles if you elect to allocate any additional savings to investments and not your bond. Depending on your earnings, between the two investments you can contribute up to R31 916 per month into products with tax-free growth.

Like my favourite aunt who always likes to ‘sit on the fence’, you can always do a bit of each: accelerate your bond payback and simultaneously create a pool of investment reserve.

I have two points in closing. The first is that the logic above does not necessarily apply to a rental property where it can be advantageous to have a high level of debt as you can write off the bond-interest against income received.

My second point is that not all access bonds are the same. Broadly speaking you get one type where your accessibility to the accrued capital amortises/reduces over the life of the bond. The other type is almost like a facility where you have access to the full value over the life of the bond.

If you use your bond effectively it can be a great vehicle to save money and grow your wealth.