You’ve got some spare cash. It could be a lump sum windfall or you may find that you consistently have some money left at the end of every month. You could invest it, but your outstanding debt is bugging you.

Should you settle your debt first?

If I was working for a big financial institution, telling you anything other than ‘Yes’ would probably get me fired – or reprimanded at the least. It’s regarded as irresponsible to encourage people to borrow to invest, which is effectively what you’re doing if you’re investing while you still have debt. But I believe the answer is not that simple and there are a few issues at stake, such as:

1. Return on investment (ROI)

What is your borrowing rate? If you owe money on your credit card at 23% interest, settling your debt would have the same effect as an investment with an ROI of 23%. (Think of it this way: If you owe R10 000, you would have needed to pay R 2 300 interest on that over the next year. By ‘investing’ R10 000 in your credit card debt, you are left with R2 300 extra in your pocket over the next year – an ROI of 23%).

Do you know of any investments that could beat your borrowing rate? According to Triumph of the Optimists, equity returned about 7% more than inflation, on average, over the past century. This makes it the best-performing asset classes over the long term. With inflation hovering just above 10% at the moment, settling your credit card (or other expensive) debt first is a no-brainer. But what about a home loan with a borrowing rate of 14%? Surely, you can find an investment with a higher ROI, you may think. But are you comparing apples with apples? With the other investment, how certain are you of your ROI?

2. Uncertainty (a.k.a. ‘risk’)

When you settle or reduce your debt, your return is guaranteed at the rate of borrowing. On the other hand, if you choose to invest in property or the stock market, there are many uncertainties. Are we heading for a long-term recession like the world’s 2nd largest economy, Japan, which could suppress the stock market for longer than you expected? Will you always have tenants providing you with steady income on your property investment? What is the next version of the current sub-prime crisis and how will it impact on your investment?

3. Cash flow

Do you have enough emergency cash in a money market unit trust or another easily accessible and stable investment product? If not, you may want to rather keep your spare cash for any unforeseen events that could really hurt you financially. Do you perhaps have a home loan account that allows you to withdraw any extra payments within 24 hours? Transferring your extra cash to this account could provide a really good, tax-free return, with the benefits of an emergency fund.

4. Tax

If you are considering investing your spare cash, how much tax will you pay on your return? Any interest and rental income over your annual allowance of R19 000 will be taxed at your marginal tax rate (the rate of your tax bracket as determined by SARS). In contrast, your return on your debt settlement is tax-free.

Have you looked at the flip-side of our tax system? Are there any investments that could provide you with some tax-relief? In other words, the more money you invest, the less tax you pay. Retirement annuities (RAs) immediately jump to mind. Liberty, for example, launched a quirky, but memorable ‘Love the Taxman’ campaign earlier this year to remind you that you can contribute 15% of your non-pension funding income to an RA and deduct those contributions from your taxable income when completing your tax return. If you’re in the 40% tax bracket, you could see an ROI of 40% due to the tax-rebate alone, and that’s before adding the growth of your RA investment over the year. I don’t know for how much longer this opportunity will be available, though. Policymakers are working on new legislation that will limit the RA contributions on which you can claim tax-relief, as there have been complaints that current legislation favours high income earners.

5. Time

Debt can keep you in a job you don’t really enjoy or make you postpone those full-time studies or travelling which you’ve been dying to undertake for so long. The sooner your debt is under control, the sooner your time is your own again.

6. Emotional benefits

Let’s face it, being debt-free can be pretty euphoric. While encouraging you to look at the hard figures like ROI and tax benefits when weighing your options, sometimes getting those shackles off is about more than just the money.

Tags: Debt, debt-free, emergency fund, RA, retirement annuity, risk, ROI

This entry was posted on Friday, September 19th, 2008 at 9:35 am and is filed under Money matters. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.