By Mike Onotsky
Whenever you have choice between two options it can be difficult to decide what to do. Debt reduction vs more investing is a question that has different answers depending on the person asking it. Everyone wants to pay down their debt as fast as possible. But, is this always the best choice if you come into a chunk of cash or have a few extra dollars per month?
If we are talking about higher interest debt like credit cards, consumer cards, second mortgages, or even many unsecured lines of credit, the answer will almost always be yes, pay it off as quickly as possible. It all comes down to the after tax return of what you might possibly earn on an opposing investment.
Let’s use the example of someone who is relatively new to investing aside from their RRSP and also has a $200,000 mortgage on their home at a longer term average rate of 3.50% (while 2.75% or less is pretty common these days). Let’s also assume they would be considered to be Balanced Risk investors and have managed a long term average in their RRSPs of 6% (the long term average for someone in their risk category).
At first glance it would seem obvious that it is better to use any extra cash to invest at 6% and pay interest of 3.5% on their debt, however, if they were to invest this cash in a non-registered investment account, they would lose a portion of the return to taxes, potentially eating up much of the difference. A more detailed thought process must be had to determine which route is better.
Another example; Clients often tell me “but when rates go up (note when, not if), I will be stuck with debt at a higher rate”. That is true. What I would do in this client’s case, however, is to instruct them to invest into a Tax Free Savings Account. This affords them much more flexibility and in a tax free environment. Since almost all mortgages allow at least 10% a year (of the original mortgage amount) to be paid down penalty free each year, I would instruct the client that if the returns received on their TFSA investments ever cross below what they are paying on their debt then they could always redeem from the TFSA to pay down the mortgage.
It Comes Down to Net Worth
You see, the secret to a sound financial plan is not just about being out of debt or savings on their own, it’s about Net Worth. The question you should always ask yourself is “how can I more quickly increase my net worth?” It should not be about “how fast can I pay my debt down” or “how much can I save by retirement”. It is all about Net Worth as we set our retirement plans.
There are many more questions that will arise out of this example…what about RRSPs, what about my investment risk tolerance, and many others. Some clients will tell me that their goal is to pay down their debt fast then start saving more, however they don’t realize that if they start saving 10 years later the effect of compounding on their investments is significantly decreased which has a big influence on the end value of their portfolios. Another very common statement is often “I just hate debt and want to be out of it”. In the end, you can’t fight that one. A client’s money is their money and they still need to sleep at night with the decisions they have made.
My role is to provide the options and the advice that makes sense for my clients financially, not emotionally. They have to inject that part of the decision making process themselves and decide on the final course of action. The conversation about savings vs debt reduction can be a complex one. Clients need to sit with an expert to determine what is best for them.
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