Should you pay off your loans or save?

By Staff Writer

At Justmoney, we are often asked if it’s best to pay off debt first or if saving is more important. Our definitive answer has always been that it’s important to pay off debts first or, at the very least, pay off more than the minimum requirement so you can cut down on the term of the loan.

 
Our sentiments this week were echoed by the Actuarial Society of South Africa, which also trumpeted the importance of paying off debt as opposed to heaping more money into savings.  They say that if you are repaying expensive debt while trying to save at the same time you are shooting yourself in the foot. This is because the cost of servicing debt is likely to cancel out the returns on savings and investments.

 

Niel Fourie, the Society’s public policy actuary, points out that while South Africa is at or near the bottom of its interest rate cycle, at 8.5% the country still has one of the highest prime interest rates in the world. “Taking on debt in South Africa remains expensive and returns on savings and investments generally struggle to keep pace with the cost of debt,” he says.

 

Repaying your home loan versus saving


Fourie says that paying off debt before making large contributions to savings makes more sense financially. He explains that those with good credit ratings generally get granted a home loan at the prime interest rate of 8.5% a year. Investments in a normal savings account, on the other hand, will probably earn interest of between just 2% and 5% a year.

 

“You are paying 8.5% a year on your home loan, but earning only around 5% on your savings. This means you are paying 3.5% more than you are earning. Depending on your tax situation your interest income may also be taxable,” says Fourie.

 

Reduce your home loan and save


Fourie explains that by paying more into a home loan than is required, outstanding capital will be whittled down sooner, reducing the repayment term and saving on interest.

 

“If you increase your monthly instalment by R1, 000 you will reduce your term to about 15 years*. By repaying more now than you have to, you will also create a safety buffer for when interest rates rise again. You can then either increase your home loan repayments in line with the additional interest to be paid or keep your payment the same if you cannot afford more, but taking longer to pay off your loan,” says Fourie.

 

Prioritise your debt

Short term debt such as vehicle and credit card debt usually attract higher interest rates than home loans, making the case for repaying short term debt a priority before investing in savings even stronger says Fourie. “Prioritise your debt from the most expensive to least expensive and start investing in the most costly one first. Once you have whittled away all the debt, you can begin investing for returns that will not be rendered meaningless by debt.”



If you still want to save alongside paying your debt, it is possible to invest in savings vehicles that pay you more interest. Fourie adds that investment options such as unit trusts that offer exposure to asset classes such as property, equities and bonds provide investors with the best way of beating the going interest rate as well as inflation. However, there are downsides. “These investments require a long-term commitment and come at a higher risk,” he warns.
 


*This is based on paying a R1 million home loan, repayable over 20 years with a prime interest rate of 8.5% with a monthly bond instalment of R8, 700 (ignoring all other bank charges).

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