Spurred on by the need to manage inflation and to protect the rand, the South African Reserve Bank has been forced to increase the prime interest rate quite rapidly since November 2021. It has now raised the interest rate by 2.75% over the past six meetings. Despite this interest rates are still 0.25% lower than pre-Covid.
With at least another 1% in interest rate increases expected over the next year, consumers are left with questions as to how to structure their budgets to achieve the best financial outcomes. Many are asking whether they need to cash in their investments or stop contributing to them in order to pay off burgeoning debt.
Financial impact of the interest rate hikes
- If you are fortunate enough to only pay prime interest on your home loan, the 2.75% increase has resulted in a monthly increase of R1 732 for every R1 000 000 of home loan over a 20-year period.
- The 2.75% increase will result in a monthly increase of R132 for every R100 000 of car debt repaid over a 5-year period.
Factors to consider before touching your investments
- Increasing interest rate cycles requires us to be much stricter on what we spend. First, start by evaluating your lifestyle expenses by cutting out unnecessary expenditure.
- If there is no alternative, stop or pause contributions before you touch your capital savings.
- Compare the long-term return on an investment versus the cost of debt. In many instances the potential growth on your investments might well exceed the cost of outstanding debt.
- Ask what the purpose of an investment is. If it is for an overseas holiday, it is better to liquidate that first rather than a saving for children’s education or for retirement.
- Determine in what asset class the investment is. It is better to use cash to reduce or pay off debt than say liquidating a unit trust or share investment. Bear in mind, too, the effect of Capital Gains Tax on liquidating investments.
What debt should be paid off first?
- If you have surplus funds available, begin by paying off the debt with the highest interest rate first. This is normally your credit card debt or personal loans, including a car finance loan. Remember to look at after tax interest rates. Interest that you can deduct against income is effectively cheaper due to the tax saving.
- If two or more debts have the same interest rate, pay off the one with the shortest repayment time. This will have the biggest impact on your cash flow.
What to do next:
- If a debt is repaid, transfer the full repayment together with increases to the repayment of the next debt. This provides the snowball effect to increase the speed with which debt is reduced. Calculations have shown that all the benefit of repaying debt is lost if even 2% of the payments on repaid debt is used to increase living expenses.
- If all debt is repaid transfer the full repayment together with increases towards savings and investments. Again, no part of the payments should be used to fund your immediate lifestyle.
- From a cash flow viewpoint, consolidate remaining debt into your home loan access account. Because this form of debt is longer term, repayments are lower. However, it is important to increase repayments into your home loan by as much as possible, as soon as your budget permits.
The risk in using investments to pay off debt is that it might result in a short-term solution that creates a long-term problem:
Many who repay debt go on to create new debt, ending up with the same level of indebtedness. Others use any savings on debt repayments to increase the cost of their lifestyle. In most cases an individual’s income is not the problem, rather his expenses. Increasing interest rate cycles requires us to be much stricter as to what we spend.
Do be in touch with your Maximus adviser for guidance before you make long-term decisions regarding how to deal with costly debt.
This article has been adapted from an original put out by PSG Konsult
