Personal-Finance

Should debt be your only priority when you get a bonus?

2016-12-21 00:16

Conventional wisdom suggests that you should use a windfall such as an annual bonus to settle your outstanding debt. The argument is that the interest paid on short-term debt tends to be higher than what one could earn in investment returns.

The problem is that if we continually use our windfalls to pay for past expenditure, we never reach a point where we are accumulating assets.

Too often, we use a windfall to settle credit card or store card debt, and then start the cycle all over again in January by going back into debt. Think about it. What happened to your last bonus? How quickly did you use that and can you even account for it or show a real benefit today?

When it comes to accumulating wealth, time really is money as the compounding effect grows our money exponentially. For example, if the investment has an annual return of 10% a year, your money doubles every seven years – R10 000 doubles to R20 000, which then doubles again to R40 000. This is what is meant by exponential growth. So the longer you are invested, the harder your money is working for you.

Another reason to put money away is so that you can create a buffer against falling back into debt. Many South Africans do not have emergency savings, which means that in the case of an emergency, when cash is needed, this is often funded by additional debt.

Putting away some of your bonus into an emergency fund is one way to ensure that you do not perpetuate the debt cycle. Mayur Lodhia, head of retail savings Old Mutual, says that while settling debt is important, it is equally important to start saving so that you do not have to rely on debt in the future. This year, consider a dual strategy of reducing debt but also accumulating wealth.

PLAN A:

PAY OFF ALL DEBT AND START AN INVESTMENT PLAN

If you are able to use your bonus to settle your debt in full, at least ensure that you stay debt-free and use the opportunity to start saving for the future.

“If you have enough money to settle your debt in full, you would have additional cash each month that would have gone to debt repayments to now allocate to a tax-free sayings plan,” says Lodhia.

For example, if after paying off your debt, you have an extra R500 a month to invest, you could put this into a tax-free saving account and accumulate nearly R100 000 in just 10 years. (This projection is based on the investment strategy of the Old Mutual Balanced Fund. These amounts are not guaranteed.) For simplicity’s sake, this projection is based on regular payments into one fund only. When investing, however, you can allocate your payments into multiple funds, and also make lump sum payments to your plan.

PLAN B:

ALLOCATE MONEY BETWEEN DEBT REPAYMENT AND INVESTMENTS

Pay off a portion of your debt and use the rest of the capital to start your emergency fund or contribute to your retirement savings.

For example, use 50% of your bonus to start an emergency fund and 50% to settle debt.

“The reduction in your debt means that your monthly debt repayments have decreased. After paying off a portion of your debt, continue to make the same rand payment into your debts as this will accelerate your debt repayments and settle your debt sooner,” says Lodhia.

For example, if you were spending R1 000 a month on debt repayments and this dropped to R500 because you paid in a lump sum, you could continue to pay R1 000, which means the extra R500 per month goes straight to settling the capital owed. Once your debt is settled, you can use the money that was servicing debt to accelerate your investment contributions as per plan A.

Save on school fees:

Most schools offer discounts of up to 10% if you pay the fees in full at the beginning of the year. This also gives you the opportunity to start saving for the following year’s school fees. For example, if you pay 2017 school fees upfront, then you save on the monthly payments for the year. If these are invested in a high-interest account over the year, then you would be able to pay 2018’s school fees upfront without using next year’s bonus.

Pay less tax:

You can invest 27.5% of your bonus tax free into a retirement annuity or top up your company retirement fund. This will boost your retirement savings by saving on tax.

Pay less for your short-term insurance:

Often, short-term insurers are prepared to give up to 15% discount on premiums if you pay them as a lump sum at the beginning of the year. Make sure you use the monthly saving to either pay off your debt faster or invest more.

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debt
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January 15 2017