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Rental income versus bond

Aug 29 2012 07:52

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A Fin24 user writes:

Two years ago I moved to a bigger place and was unable to sell the townhouse I was living in at the time, so I opted to rent it out.

My wife and I are expecting our first child soon and I am weighing up the pros and cons of selling the place to get the my debt/equity a bit more in line with our income.

Currently the rental income I get covers the bond, the rates and the levy, so effectively it is costing me nothing.

However, with a baby on the way our gross income is not large enough should we fail to get a tenant to occupy the house in the near future.

Should I risk it and keep renting the place out, or is now a good time to sell ?

Some stats that might help:

Value of the townhouse six months ago: R630 000, bond amount on it R429 000;

Value of my current home R1 350 000, bond outstanding R625 000.

Once the baby is here I won't be able to save more than R400 – R1 000  a month.

My thoughts were to net out about R160 000 and put it straight into my bond in a fixed deposit of some sort.

Gregg Sneddon of www.thefinancialcoach.co.za responds:

The users are wise to think about the issues before the birth of their child, and I think that this is one of those "there is no right answer, just different scenario" questions.

Having said that, I am a huge fan of living debt free so my answer is based on the option which is more likely to get them out of debt quicker as well as ensuring that their cash flow is kept intact – they don't need additional stress in their lives when there is such a major life event about to unfold.

So in short, I am in favour of selling the rental property and have done some rough calculations below.

Assumptions:

Bond rate: 8%

Remaining term on the bond: 15 years

Marginal tax rate: 30%

Purchase price of the rental property: R450 000

Selling price: R630 000

  • There is likely to be capital gains tax (CGT) on the sale of the rental property, so they will need to do the maths and work out what they are likely to get out after all costs have been deducted. For argument's sake, let's assume they bought it for R450 000 and that they can sell it for R630 000.

The capital gain would be R180 000 and the taxable gain would then be 33.3% of R150 000 (the annual exemption is R30 000) – so if we assume a marginal tax rate of 30%, they could expect to pay around R16 000 CGT.

  • This would mean that they would net around R184 000 after the bond has been settled (R630 000 less the bond = R200 000 profit, less the R16 000 CGT = R184 000 net)
  • There would be little or no change to their cash flow as a result of selling the flat, as it was paying for itself. Rather, they would have peace of mind knowing that they are not at the mercy of a defaulting tenant.
  • If we assume that the bond rate is 8% and the remaining term is 15 years, then the current monthly payment should be just under R6 000 per month and the total payment over the remaining term would be R1 075 000, with around R450 000 of this being interest.
  • If they now pay the R184 000 into their bond and keep the repayments as they are (ie R6 000pm), then the term would drop to just over eight years and the total amount repaid would drop to around R609 000, with about R168 000 of this being interest.

To my mind, given that they can't afford to cover a tenant who defaults, this is almost a no-brainer (I am also a big fan of getting rid of debt as quickly as is possible).

  • The additional cash in the bond would also give them access to an emergency fund (just make sure that you have an access facility on the money before you pay it all into the bond).
  • I would stay away from using anything other than the bond as the interest rate on just about anything else is likely to be quite a lot lower than the bond rate (money markets are giving around 4.5-5% at the moment).
  • The additional saving that they could make each month (R400 - R1 000) should also go into the bond. R400 extra will reduce the remaining term by around 11 months and R1 000 by around 20 months.

This means that the bond would be paid off in under seven years – around the time the child will be heading off to school - and they can then pay the school fees out of cash flow and continue to live debt-free.

At least three other issues also spring to mind:

  • They need to make sure that they have a valid will in place – it must specify guardians and trustees who will look after their child and the money if anything happens to the parents.
  • They should do a stock take of all their insurance and investment policies, and make sure that they still have appropriate amounts of life and disability cover.
  • They need to make sure that the premium for their home owners' insurance is competitive and that it does not come off the bond, as they will end up paying interest on the premium over the entire term of the bond. It should rather come off their bank account.
  • And finally, in my opinion they should stay far away from things like education policies. Rather put every little cent into the bond and get rid of it as quickly as possible – you will get a better return than in any policy and living debt-free is an incredible place to be.

 - Fin24

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