What came first?

In the previous posting I mentioned two golden rules of financial management.

1. Get rid of personal debt and
2. The sooner you can start saving, the better.

The question now is if I have personal debt (not the same as debt used to finance some business activity like a bond on a rental property), do I re-pay the debt before I start investing into something else like shares, or do I allocate some money to the re-payment and some to investing, or do I invest everything?

In my opinion the answer 90% of the time should be to get rid of the debt before you start investing, BUT, we are experiencing unusual times at the moment and my current opinion falls into the 10%.

Why should one re-pay debt? Here are some reasons:

• Let's say your bond rate is the same as the current Prime Interest Rate, 15%. So, the bank charges you 15 cents(15%) per year for every rand you borrowed from them to buy your house. Now at the end of the year, you owe them R1.15. If you give them back their R1 rand at the beginning of the year, you saved the 15 cents interest.
• This 15 cent saving is guaranteed. You know that you will have 15 cents in your pocket at the end of the year if you give your bank back the R1 at the beginning.
• The 15 cents is tax free. Because you have 15 cents in your pocket at the end of the year because you paid the bank the R1, does not allow the Receiver of Revenue to tax you on it.

Now if you decide to take that same R1 and not give it to the bank as re-payment of your bond, but decide to invest it in a share, the following will apply:

• You have no idea what the amount of money is the share will give you at the end of the year. It might be 15 cents, 20 cents or even -30 cents. The point is that the return on the share is not guaranteed.
• The other disadvantage is that the return on the share is taxable.

So, if you re-pay your bond it is the same as getting a guaranteed 15% tax free return on your money.

If you invest the R1 in a share, you don't know what you will get back, if anything, and whatever you get will be taxed.

So why do I say that we currently have to consider our options between re-paying debt and investing in shares? Here are the reasons:

• You can buy the shares of big, well managed, profitable companies all over the world for on average 35% less than you bought them 12 months ago. Some of these companies will also pay you an annual dividend of up to 5% which is almost tax free.
• Interest rates in South Africa are coming down so you might only have to pay 12 cent (12%) on every R1 outstanding on your bond soon.

To sum up, If you have to decide what to do with an extra R1 in your pocket, ask yourself this question:

- Can I get an after tax, guaranteed return of more than my bond rate by doing something else with the money?

If the answer is yes, then do it, if you don't know and have some appetite for risk, then go 50/50. If you have no debt, start investing.

I will look at some investment alternatives in the next posting.

Please remember that the aim of this blog is to make you think and consider alternatives and not to give you professional advice. For advice you can contact me or your licenced financial advisor.