What do you spend your money on when you have extra cash coming in? Taking advantage of the low-interest rates to pay off your mortgage may seem like a great idea. Or you could invest that extra money into your retirement, your children’s college funds, or other financial goals. They’re both great ideas, but which is the right option for you?
Let’s assume you’ve just paid off your credit card debt and now you have an extra R5,000 a month. What is the best way to spend this money?
Should you be paying off your mortgage or should you invest?
There are two arguments to this question.
Some financial experts may tell you that you should pay off your mortgage as soon as possible and invest afterwards.
On the other hand, some experts may tell you that you should keep paying your mortgage as usual and invest the extra money you have.
The truth is it all depends on your financial goals and risk tolerance.
Calculate the opportunity cost
Deciding whether you should pay off your mortgage or invest any extra money you have can be a difficult choice to make. To help you come to a conclusion, weigh up your options and choose the one that would best suit your financial needs the best.
You do this by calculating the opportunity cost. When choosing an option, the opportunity cost refers to the benefits you’ll lose out on if you had chosen the alternative option.
What would the opportunity cost be if you had to choose between investing and paying off your mortgage.
Paying off your mortgage
Let’s assume you have an R550,000 balance and 15 years remaining on your mortgage, and you’re paying an interest rate of 9%. If you paid an extra R5,000 per month towards your mortgage, you’d be saving about R304 542 and your mortgage would be paid off within 5years.
You would be saving money because you’d be paying off the mortgage interest rate and the balance. This will reduce the total amount you’re paying back.
So an extra R5,000 can take you a long way.
Before you go ahead and start throwing extra money towards your mortgage, take a step back and assess your options.
Investing your extra money
Now that you know how much you can expect to save if you’d pay off your mortgage with the extra money. You need to calculate what you could earn if you’d invest the extra money.
How much money would you make if you’d invested that extra cash?
Calculating your return on an investment is extremely difficult. That’s because you can’t predict the future. No one can truly say for sure what the stock market, property market or any other type of investment will do in the future.
However, you could use past results to help determine future earnings.
For example, if you invested R5 000 per month in the S&P500 from August 2015 to August 2020 (5 years), you would have seen a good return.
If you invested your money over that period you would have invested a total amount of R305 000 and earned roughly R433 939. That’s a 14% annual return on investment.
However, this value does not include capital gains tax. The South African capital gains tax can range from 7.2% to 18%, depending on your tax bracket.
To determine whether you should invest your extra money, you should calculate what you would be paying in tax.
To do this you need to deduct the capital gains tax from the money you’ve earned from the investment. Let’s calculate that using the example above.
Total amount invested: R305 000 (R5 000 over 5 years)
Total earnings: R128 939 (R433 939 – R305 000)
Capital gains tax: R23 209 (R128 939 * 18%)
Total return (after tax): R410 730 (R433 939 – R23 209)
So, if you invested R5 000 in the S&P500 for the past 5 years you would have earned roughly R410 730.
It is important to keep in mind that these calculations are based off past results and that these are only estimations. Any investment can change overnight, and no one can predict what the market will do in the future. You only use these figures as guidelines and not as fact.
Making the final decision
Based off our calculations above investing in the S&P500 would offer better financial returns. However, to fully evaluate the opportunity cost you have to take into account your personal financial goals and risk tolerance as well.
To do that you’ll need to ask yourself some difficult questions.
For example, what does your financial portfolio look like in 5 to 10 years from now? What would it mean to you to pay off your mortgage in full? Does that offer new investment opportunities? What would you do with the extra cash once your mortgage is paid off? Can you handle the risk that comes with a volatile stock market?
Once you fully understand what your financial goals are and how much risk you can handle, it will be easier to make the difficult decisions.
Ultimately you want to be as flexible as possible and adapt to any changes in the economic environment.
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