Structuring your bond: Consider the lost opportunity costs

With interest rate increases coming into effect both locally and abroad, many homeowners are focused on paying off their bonds as quickly as possible to save interest over the long term. While this is commonly accepted as being good advice in that it results in interest savings, it is also important to factor in the lost opportunity costs of making higher bond repayments.

Paying off a bond is a long-term commitment and is generally the most cost-effective debt one is likely to access in one’s lifetime. As such, it is important to take a step back and holistically review your financial objectives over this period. Although paying down debt and saving on interest makes sense, very often one’s Net Asset Value (NAV) over this period is overlooked. Buying a property and funding for your retirement are likely to be the two longest-term financial undertakings most people will make, and the decisions you make at the outset of these journeys can have a significant impact on your longer-term financial future. In this article, we explore the longer-term effects of a 20-year bond versus a 30-year bond in relation to one’s retirement funding, with the objective being to target the greater Net Asset Value.

In this example, we have assumed that John earns a gross monthly income of R65 000. He purchases a property for an amount of R3 million and makes a 10% (R300 000) deposit on the property. He applies to his bank for a bond of R2.7 million and is offered an interest rate of prime, which is currently 8.25% with the option to pay off the bond over either 20 years or 30 years. Keeping in mind that John also wishes to fund for his retirement, he needs to consider the two home loan financing options which are as follows:

20-year bond 30-year bond
Initial loan R2 700 000 R2 700 000
Interest rate 8,25% 8,25%
Monthly repayment R23 005 R20 285
Total interest over the term R2 821 385 R4 602 311
Total payment over the term R5 521 385 R7 302 311

John considers taking the 20-year option to pay off the bond in order to pay as little interest as possible. He reasons that once he has paid off his bond, he will then redirect his bond repayments towards a retirement fund for the last 10 years leading up to formal retirement. In implementing this approach, John will be able to allocate a monthly amount of R29 786 per month toward his retirement savings from the R23 005 bond repayment once the maximum tax saving on retirement fund contributions is factored back into his saving. Assuming he receives a net return of 9% per annum from his retirement fund investment, after 30 years John will have a fully paid for property and a net investment value of R5 764 016.

Now let’s look at the 30-year bond option. Should John opt for a 30-year home loan, he can allocate the net difference in his monthly cash flow toward his retirement funding over this same period. As the retirement fund contributions are tax-deductible and he is a disciplined investor, John is willing to commit the net equivalent of the R23 005 bond repayment to this structure. The net result is a monthly retirement fund contribution of R4 459 based on his tax bracket:

20-year bond 30-year bond
Income  R         65 000  R         65 000
Less: PAYE -R         17 365 -R         17 365
Net pay  R         47 635  R         47 635
Less: Bond repayment -R         23 005 -R         20 285
Less: RF contribution  R                  – -R           4 459
Add: RF tax rebate  R                  –  R           1 739
Net cash  R         24 630  R         24 630

If we assume over the 30-year period, John’s retirement fund contributions once again generate a net investment return of 9% per annum, he will have a net investment value of R8 163 285 at the end of this period. Although John has paid more in interest over the 30-year period, by reinvesting the difference in a tax-efficient manner, he has created more long-term value in his balance sheet over 30 years. If we assume that the value of John’s property simply grows in line with inflation (assumed to be at 6%, his position after 20 and 30 years respectively would be as follows:

20-year bond 30-year bond
Property future value @ 6%  R 17 230 473  R 17 230 473
Investment Value  R   5 764 016  R   8 163 285
Net balance sheet  R 22 994 489  R 25 393 758

It is important to note, however, that the purpose of this article is not to determine that a longer-term bond is a better option than a shorter-term bond. The purpose is essentially to highlight the importance of making financial decisions with your whole portfolio in mind so that you can fully appreciate the lost opportunity costs that may result from your decision-making. Remember, several other factors should also be considered when determining the best structuring of your home loan, including where you sit on the tax tables and the interest rate offered by your bank. Generally speaking, the higher your tax rate and the lower your personal interest rate, the more effective it would be to finance your property purchase over a longer period. Conversely, the lower your tax rate and the higher your interest rate, the less impactful a longer-term home loan would be.

Keep in mind that if interest rates rise it is possible to lower one’s retirement fund contributions to adjust for the higher monthly payments if your cashflow necessitates this – but, if you are already near your limit in respect of your monthly repayments on a shorter-term bond, it can be difficult to find the additional funding to maintain your monthly repayments. You also have the option of making additional payments to your bond to lower the total interest paid over the period and build an access facility within the bond if your agreement allows for this.

In summary, it is important to consider your overall wealth creation objectives over the longer term when structuring your home loans, keeping in mind that seemingly small decisions can have a significant impact on your Net Asset Value over time. Ideally, one should strive to find a balance between servicing debt and funding for retirement, and we recommend that you consult with an independent Certified Financial Planning® professional to help you achieve this.

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