For most young people just getting out of debt is the main priority, however what if you are one of those rare “savers” who have saved a lump sum by the time you are in your early 20’s – where is the right place to invest it and how to you balance your savings with lifestyle needs?

Rob is a 22 year old who recently finished studying and has started his first job. Since the age of 16 he has saved money from part-time jobs and side businesses and made some astute investment decisions. As a result he has saved up R360 000 and bought his car with cash.

Most of his money is invested in equities through unit trusts and his own share portfolio, but now he wants advice on what the next step should be. Is it time to invest in property and what about increasing his retirement savings?

“I have R65 000 saved in a money market account and I want to know whether I should use this money to put down a deposit on a property or to continue with my share investments,” asks Rob. In addition he has around R4000 a month that he is able to invest and currently he contributes 10% of his salary to his company’s provident fund. He also wants to know if he should take out a retirement annuity.

“Rob is the classic example of a Warren Buffet type student who is optimizing the compound effect of growth,” says Derick Ferreira, national marketing manager at Old Mutual.

The key to Rob’s success is that he started saving young and has therefore benefited from the growth of his investments. Of the R360 000 he now has, only around R140 000 came from actual savings – the rest is from pure growth from his investments. If he had spent that R140 000 on a flashy lifestyle he would have little to show for it, yet today it has grown to R360 000.

Rob’s financial success has also been a result of the fact that he saved in a growth asset, namely equities. If he had just invested in cash earning between 5% and 6% then his return would have been much lower.

If Rob never saved another cent but simply continued to invest his current lump sum in a growth investment that delivered an undemanding 10% a per year, he would have R2.6 million by the time he is in his 40’s.

“People always ask ‘where should I invest, who is the best asset manager’ – the key is to invest in time because the sooner you start investing, the more you benefit from compound growth,” says Ferreira who says consumers often confuse “wants” and “needs”.

“A person may want a big house and a fancy car, but what they really need is transport and a roof over their head,” says Ferreira. Rob chose to live what he called “a Spartan lifestyle” and while meeting his needs he has postponed his wants in order to build capital. “Once you have excess money and you want to spoil yourself, you are in a position to do so, as long as you have the means to do that,” says Ferreira.

Rob has done all the right things but has reached a stage where he needs individual, expert advice. “Now would be a good time to sit down with an accredited financial adviser and do a proper financial analysis,” says Ferreira. Although Rob is clearly an astute investor, a financial adviser can provide a sounding board for his investment ideas and also assist him to assess what his goals are for the next five to ten years. Having a clear idea of where you are and where you are headed helps to inform your investment decisions.

Investing in property

Ferreira says while debt for consumption is “bad debt”, there is also “good debt” and that is when you are investing in something that can grow such as property. Most people want, at some stage of their lives, to own a home and very few are able to buy it with cash, so debt is necessary. As long as you are able to afford the repayments and do not over-extend yourself then taking on debt for property is not a bad thing.

Rob is specifically looking at property as an investment in order to rent it out.  Ferreira says that buying a property at this stage could be a good diversification as it exposes him to another asset class.

In terms of using the money market funds as a deposit, Ferreira says one just needs to look at the relative returns of a money market fund versus paying off a bond. At best Rob would receive around 5.5% on his money market fund and some of the interest could be taxable, depending on the total amount of interest earned in the tax year. On a mortgage Rob will pay around 9% in interest so by using the money market funds as a deposit he is in fact creating a risk-free “return” of 9% by not incurring interest on that portion of the mortgage.

Currently fund managers believe that the South African equity market is overvalued while residential property prices are relatively weak and estate agents refer to property as a “buyer’s market”.  This means that Rob may find more investment opportunities in buying property with his R65 000 than investing it in South African shares.

Investing in a retirement annuity

In terms of a retirement annuity, Rob should first ensure that he is contributing to the maximum level in his provident fund. Company retirement funds tend to have lower fees than a retirement annuity.

However Ferreira says Rob must ensure that he is maximizing his tax benefits by contributing the maximum amount into a retirement annuity that is allowed as a tax deduction.

Underlying investments in retirement annuities are also exempt from capital gains tax and dividend tax. It is estimated that this tax saving boosts the final return by around 10%.

Rob can invest the greater of R1750 a year or 15% of all non-retirement funding income into a retirement annuity. This means 15% of all income that is not used to calculate his current 10% provident contribution. This would include non-pensionable bonuses and any other source of income outside his salary.

Ferreira says Rob should calculate his tax effective contribution at the end of the tax year in February each year and make the payment into a retirement annuity. He will then qualify for a tax rebate which Rob  could use to invest in discretionary savings such as unit trusts or his own share portfolio. If one uses the tax rebate to go on a shopping spree you negate the tax benefits for saving purposes.

Your home vs buy-to-let

Buying a property to live in is very different to buying property as an investment. If you are looking for somewhere to live, you will consider factors such as where your work is and a community that provides schools or easy access to shops. It is largely a lifestyle decision and also an emotional one. It not only makes financial sense to pay off your asset rather than someone else’s through rent, there is also an emotional need to know the place belongs to you.

However one should still apply sound financial decisions and not overpay for the property just because you like it. Make sure you can afford the repayments as well as all running costs including electricity, levies and rates and taxes. Also factor in any potential interest rate hikes. Although the banks prefer you to have at least a 10% deposit, the more deposit you have the better. You should also only buy if you have a fair idea that you will be living there for at least five to seven years. When you buy and sell property there are other costs incurred such as transfer fees and estate agent fees and it takes time to recoup these through the price increase in the property.

When investing in property your decisions will be very different. You will need to find an area where there is a high demand for rental property which may be an area you are not living in. Do your homework in terms of the rental you will receive – never leave that to the silver-tongue of the estate agent! Rule of thumb is that the annual rental should be at least 10% of your purchase price – so if you purchase a property for R500 000, then the annual rental should be R50 000 or around R4100 per month. Also factor in other costs such as levies and rates and taxes.

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 This article first appeared in City Press