Why debt need not be a four-letter word

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indexWhenever people get their hands on a significant sum of extra cash, their thoughts tend to turn to paying off some debts – including paying in extra on their bond/s. However, I strongly encourage you not to pay off bonds which you hold on your property investments.

I can explain why you should not pay off these bonds using a simple but concrete (excuse the pun) example, which also shows you how to build a property investment portfolio. Imagine two brothers, Peter and Paul, each with R40, 000 to invest back in 1980:

  • Peter used his R40, 000 to buy one investment property. He held onto it, and it is now worth R1.5m. He has no debt.
  • Paul used his R40, 000 to buy four investment properties. He put down a R10,000 deposit on each and took out four bonds of R30,000 apiece or R120,000 in total. Today his four properties are worth R6m. Say he did not pay off any of his bond over that time, and still had a debt of R120, 000 – it’s pretty minor, I am sure you will agree, compared to the total value of his property investment portfolio.

Let’s take this example further. In 1990 the brothers each received an inheritance pay-out of R100, 000. By then each investment property had also increased in value to R100, 000:

  • Peter bought another property. Today he has two investment properties, which together are worth R3m.
  • Paul bought another four properties: deposits R25, 000 each, bonds R75, 000 each or R300, 000 in all. Today he has eight properties worth R12m vs. a bond debt of only R420, 000.

Think on this – Paul could have used his R100, 000 windfalls to pay off most of his R120, 000 debts on the first four houses. If he had, then today he would still ‘only’ have four investment properties worth R6m and a debt of R20, 000. I know which scenario I prefer!

So, if you get your hands on a bit of a lump sum, why use it to pay off part of the bonds on your investment properties if you can use it as a deposit to buy another property for your portfolio? (Look around at distressed properties and below market value properties to get the best deals.) Paying off part of your bond also reduces your interest payments, which in turn reduces your tax deductibility, which in the big scheme of things means that your overall rate of return drops.

Basically, in the case of investment property debt is not a bad word: debt on assets that appreciate is always good. Your debt stays the same, but the assets against which you have the debt keep going up in value. In fact, once they do go up in value, refinance them to release some of the equity and go out and buy more properties!

Remember though that in the case of depreciating assets – like that convertible, the jet ski and the big-screen TV – debt remains a bad thing to have, and should be got rid of as soon as possible.

Madelein Kottnitz

Madelein Kottnitz

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