Last week Thursday, this “reader’s question” was answered in a Moneyweb article:
A few of my readers asked me for my take on this – and specifically, my take on the response. I’ll be honest: this made me quite uncomfortable. Here’s the relevant section of the response:
Let’s say for example the property you are purchasing is R1 200 000. If you take out a bond with no deposit at a 10.25% interest rate, you will pay R11 779.72 per month over 20 years. At the end of the bond term, you will have paid back R2 827 132.95
On the other hand, if you could put down a R100 000 deposit, the monthly repayments will be R10 798.08, and the total repayment will be R2 591 538.54. If the deposit is added to this, the total still only comes to R2 691 538.54. In other words, you would save R135 594.41.
Which is a bit, you know, “highly simplified”.
But because this involves amortisation tables and monthly repayments, it’s not so easy to see why this might not tell you the full story. Let me try to give you a different example of a similar argument.
Let’s say that the question was rather “I have sugar in my tea every day. My fiancé says I should stop having sugar in my tea, because in the long-term, it will make me fat. What would you advise?”
And here’s some similar logic:
Let’s say, for example, that you have 2 spoons of sugar in your tea; and you drink 4 cups of tea daily. Each spoon of sugar weighs 8 grams. Over the next 20 years, you’ll have drunk about 234 kilograms of sugar. And if you keep having it, you’ll weigh 234kg more than you do now. So stop having the sugar.
The trouble is: the conclusion is fine.
As in: sensibly speaking, the guy should probably just pay the deposit; and also, having less sugar in your tea is a good thing. But you’re almost certainly not going to weigh 234kg more if you keep having sugar in your tea; and you’re equally not going to save R135,594.41 if you go down the path of investing the deposit elsewhere (because that deposit is going to earn interest/returns, which will offset the incremental saving).
That said, there is a reason that I’m uncomfortable with over-criticizing this particular piece of advice. And that’s because, well, it’s advice.
If someone is asking you for your professional guidance, you don’t engage them in an existential argument to cover all the ramifications of every possibility, alternative, and school of thought. They’re expecting you to have already done that, and to have come to a good and justified answer. After all, you’re the professional.
Only, when you give that answer, you’re expected to condense all of that groundwork into a justification that is simple and easy to understand, so that the recipient of said advice can feel comfortable taking it. And in that moment, it’s sometimes best to fall back on people’s internal rules of thumb. Things like “A decision is a good one if there’s a cost saving – and the bigger, the better” or “A moment on the lips, a lifetime on the hips.”
With that in mind, here is the more important part of the advice:
Being a primary human need, housing is always in demand and if you have chosen one in a good area, you should see growth in value at least linked to inflation.
Overall, property is a great investment, however if you are going to acquire it through a loan you want to do your best to minimise the loan as well as the term of the loan to save on interest. That way you can enjoy more years of earning rental income that will be coming into your pocket instead of it going towards loan repayments.
That is the solid advice. And the way I read the column, the math example is there more to give emotional support to that conclusion – so who cares if it ignores the fact that the deposit would have earned interest if the fiancé’s advice had been followed and the money invested elsewhere?
And I’d end this post here, except for the fact that the entire point of this blog is financial literacy.
So let’s review that example.
The more existential argument
There are two sides to this story:
- On the one hand, the deposit can be used to reduce the amount of interest being paid (Option A).
- On the other, the deposit can be invested elsewhere to earn higher interest (Option B).
Here is the base case again:
Let’s say for example the property you are purchasing is R1 200 000. If you take out a bond with no deposit at a 10.25% interest rate, you will pay R11 779.72 per month over 20 years. At the end of the bond term, you will have paid back R2 827 132.95.
Under option A, here’s what will happen:
…if you could put down a R100 000 deposit, the monthly repayments will be R10 798.08, and the total repayment will be R2 591 538.54. If the deposit is added to this, the total still only comes to R2 691 538.54. In other words, you would save R135 594.41.
And that saving is “saved interest”.
And then there’s option B. So let’s say that Option B involves putting the R100,000 into a fixed deposit that earns 6% compounded monthly. In this situation:
- You’d still have paid back the R2,827,132.95 on the investment property (ie. you’d pay the extra R135,594.41 in interest).
- But you’ll also have a fixed deposit that’s worth R331,020 at the end of it (ie. you’d have earned an extra R231,020 in interest).
- So your “net” payment position is R2,496,113, which looks a lot better than option A.
“Hold up!” I hear you say. “It looks like it’s much better to put the R100,000 into a fixed deposit that earns less than 10.25%? Whaaaat?!”
Well, you see, this is why it’s so easy to get confused in this type of example. At this point, the basic problem is that I’m comparing:
- Trying to finance a R1.2 million property with deposit and a mortgage (Option A); with
- Buying a R1.2 million property AND having a R100,000 fixed deposit (Option B).
Obviously, the second option is better if you’re looking at it like that.
So if you want to look at it in a strictly comparative sense, you have to compare:
- Financing a R1.2 million property with a R100,000 deposit and and R1.1 million mortgage; and
- Financing a R1.2 million property with a R1.2 million mortgage and a R100,000 annuity investment that pays you R981.64 each month (to cover the shortfall between Option B’s monthly repayment of R11,779.72 and Option A’s monthly repayment of R10,798.08).
Not-so-funnily enough, that annuity has to earn a 10.25% return in order to pay out R981.64 each month.
So the investment property buyer is actually faced with this choice:
- Earn a guaranteed return of 10.25% a month on his R100,000 deposit (because that is the saving); or
- Try and earn a higher return elsewhere, and save whatever he/she can extra.
A 10.25% guaranteed return? That’s pretty hard to beat.
It’s why the generally sound advice is
Overall, property is a great investment, however if you are going to acquire it through a loan you want to do your best to minimise the loan as well as the term of the loan to save on interest.
However, an even better suggestion
Because we’re intuitively bad at knowing the difference between Option A and my original Option B, why not do both? If you can’t tell the difference, then you won’t notice if:
- You throw the R100,000 into the bank as a deposit to earn the guaranteed 10.25% return; and
- You keep the original repayments (ie. you add the R981.64 per month that you’d save on the repayments to the monthly repayment, which means that it will also earn a guaranteed 10.25% return).
That way, you’ll have repaid the full loan amount over four years ahead of schedule, and saved yourself an extra R300,000 or so in interest.
Let’s call that Option C.
Could you do better than that by putting the R100,000 into a Satrix ETF? Maybe.
But my view on this is: if you’ve already made the decision to buy an investment property, then you’ve already made the decision to invest in property. From that point onwards, the only important question is: “How do I most efficiently invest in this property?” And the answer is almost always: “By paying down the capital faster, because it’s hard to beat the guaranteed return of the saving.”
For more on this, here’s an earlier post: Rent or Buy: Paying Off A House In 7 Years
Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.
danie March 8, 2016 at 09:44
what about tax?Reply
Jayson March 8, 2016 at 10:02
Haha – I’m tempted to reply “Well yes, there will be tax.”
The thing is, there will always be tax, but the tax is always a percentage of your profit, right? So if you target better returns, you’ll pay more tax, but you’ll still earn better returns.
There might be ways to make your decision-making more efficient. And depending on your circumstances, you may decide to put that R100,000 into assets that generate tax-free returns (like tax-free savings accounts, etc), while using the higher cost to pay less tax on your other income. But that’s a different (and highly specific!) conversation, that will come with other risks.
As a rule of thumb though, it’s generally best to look at the decision pre-tax, and then work the tax from there (unless you have a specific tax structure in mind from the get-go).Reply
Brian March 8, 2016 at 12:41
The one part here where this can get tricky is the fact that the mortgage repayments are tax deductible (well the interest portion).
With your initial bond repayments this is the vast majority of the bond repayment and can be a significant amount.
Going on the two options above, choosing to not put the deposit into the house and rather invest it, you effectively save more tax on the mortgage payments (as these are now larger) and you can also choose a tax free savings mechanism for your deposit that you choose to invest elsewhere.
So although tax will always be a % of your profits, the deductions you are allowed to include to reduce that profit and turnover that is then exempt from the calculation could change this decision slightly, it does make the calculation a lot more complex and then follows your “that’s a different (and highly specific!) conversation”
However I do think there are quite efficient tax principles to be used.Reply
Jayson March 8, 2016 at 13:15
Thanks – I do agree with you that there are some very tax efficient ways to do these things!
That said, if you take the first year as an example, the relative interest saving is R10,176 (I know you don’t have the spreadsheet in front of you, but I hope you can take my word for it). Even assuming a top marginal tax rate of 40%, that’s going to be a “tax saving” forgone of R4,407. So that’s a 4.4% opportunity cost on the deposit, which could potentially be added to the return that the R100,000 could earn elsewhere.
Except only R30,000 of the deposit can be put into a tax-free saving account (assuming that the account isn’t already maxed out with other savings). And even if we assume that the R100,000 could earn an equivalent interest return of R10,176, only R3,053 would be tax-free, so the marginal tax benefit is R1,221. That is: there is a 1.2% opportunity cost for the tax loss in that first year, which is where it would be highest.
So in that first year, I might say “Can you beat a ±9% guaranteed ‘economic’ return?”
Although it’s confusing, because doing the comparison still requires me to look at it as though we’re discussed a R100,000 annuity.
Basically, if you’re going to involve tax, then I think that we should only discuss two options:
1. Putting the deposit into the mortgage, and continuing to pay R11,779.72 per month; or
2. Putting the deposit into another investment, and continuing to pay R11,779.72 per month.
And just forget the lower monthly payment option altogether. #changethequestion 🙂Reply
Kosta March 8, 2016 at 14:36
And as always, the “returns” you achieve from sticking excess cash into your bond (as opposed to investing it) are tax-free 🙂
Granted, with your example of R100k invested at 6%, you probably won’t exceed the annual tax threshold on interest income; but it’s certainly worth considering for larger deposits (and / or if you choose to invest the cash in equities that end up incurring CGT).Reply
Kosta March 8, 2016 at 14:37
For some reason the previous comments pointing out the tax implications didn’t show up; pardon the redundancy. Feel free to delete.Reply