Wealth Insights - July 2016

Wealth Insights

July 2016

Is Paying Down Debt Always the Best Move?

Should you invest instead? Record low rates make it time to revisit the debate.

With the ratio of debt-to-disposable income flirting with all-time highs, it’s no wonder polls say dealing with debt is a top financial priority for working Canadians. The desire to pay down debt is usually hard to argue with. But in an era of rock-bottom interest rates, is putting debt reduction ahead of other key goals like saving for retirement or your children’s education the best move?

Whether to pay down debt or invest can be a complicated decision that often goes beyond the numbers. Here’s what to consider before you choose.

Separating good debt from bad

Debt represents an obligation to be repaid. But that doesn’t mean it’s all the same.

Think about your mortgage, for example. Those mortgage payments are like forced savings, helping you purchase an asset, a home, which is likely to appreciate in value over time. There are other types of ‘good’ debt, including loans to fund education, start a business or invest. A dollar of interest paid on an investment loan intended to generate interest income or dividends is generally tax-deductible, creating the same deduction as a dollar contributed to an RRSP.

But not all borrowing has a financial upside. Credit used to bankroll a lavish lifestyle is typically ‘bad’ debt, which drains wealth. More often than not, it’s the kind of borrowing that goes hand-in-hand with high interest charges.

It makes sense to get rid of expensive credit as soon as possible. Paying off a credit card charging 19% interest is the equivalent of earning 19% on an investment – after tax and guaranteed – a return that’s difficult to find in any market.

Pay off debt or invest?

Prioritizing paying down costly consumer debt over investing is an easy decision. But, what if your only obligation is a mortgage with a 3% interest rate? Is debt reduction still the best choice?

How you’re planning to invest your money will affect your evaluation. Take the option of contributing to a Tax Free Savings Account. Because taxes aren’t an issue, if the expected rate of return from your TFSA investment exceeds the cost of your debt, you have a good reason to invest first.

Taxation, however, clouds the picture. If you’re investing in a taxable account, your marginal tax rate can make a huge difference to your net return.

Say, for example, you’re in a 40% tax bracket. A fully taxable investment would need to generate close to 7% pre-tax to deliver the same financial benefit as paying down a 4% loan.

Contributing to an RRSP adds other wrinkles. It’s necessary to put the amount of the tax deduction, the potential for investment growth over time, and the expected tax hit when the funds are eventually withdrawn, up against your loan rate. For this you’ll likely need your advisor’s help to work through the figures.

Risk: the other side of the coin

While crunching the numbers is important, it shouldn’t be all that goes into your decision to invest or reduce debt. You also need to weigh the risks.

The beauty of paying down debt is it delivers a guaranteed return. You can calculate the pay off upfront. But when you invest, your rate of return is usually less than certain, particularly in the short term. And, if your investments don’t pan out, you’ll still have debt hanging over you with fewer assets to rely on later.

While equity markets have proven to be a solid wealth generator over time, favouring them over paying down debt is most appealing when you have a long investment horizon. As the chart below shows, Canadian stocks delivered close to a 9% average annual return over the 25-year period ending in 2015. However, it’s also true equities lost money about once every three years during that stretch.

That means if you’re years away from retirement – and can ride out the market’s ups and downs – compound growth from investing has the potential to add thousands of dollars more to your net worth in the end than chipping away at your low-rate debt.

Registered Retirement Savings Plan contributions, and the tax refunds they generate, can boost your savings further, particularly if you’re in a high tax bracket or your tax rate falls in retirement.

That said, if you’re conservative by nature or your debt load would make it difficult for your budget to absorb a moderate bump in interest rates, the peace of mind and safety achievable through debt repayment is hard to ignore.

Don’t overlook these factors

When deciding whether it’s best to pay down debt or invest, how you answer the following questions can tip the scales.

Do you have realistic expectations for future investment returns?

If sluggish global growth persists, nominal returns on stocks and bonds may be lower going forward than they have been historically, in part reflecting expectations for weaker inflation and softer corporate profits. Don’t make the mistake of putting today’s borrowing rates next to investment returns achieved under vastly different economic conditions. It’s wise to take a conservative view on future investment performance when comparing investing to paying down debt.

Are you tying up too much of your wealth in your home?

Investing in a diversified portfolio of stocks, bonds and cash spreads out risk and gives you multiple sources to generate returns. On the other hand, committing all your effort to paying down your mortgage concentrates your wealth in a single asset: your home. That leaves your net worth vulnerable to a serious price drop in Metro Vancouver’s red-hot real estate market.

How close are you to retirement?

Most experts agree that minimizing or eliminating debt altogether heading into retirement is beneficial. Doing so allows you to direct cash to a more satisfying purpose, whether that’s travel, hobbies or helping out family. Plus, when you reduce your obligations you lessen the risk to your savings from threats like rising interest rates or health care costs, giving you peace of mind.

Are there additional tax benefits to investing you might miss?

Certain investments offer unique advantages you should think twice about passing up.

A Registered Education Savings Plan is one example. Along with tax-deferred growth, you’re eligible to receive free money for your children’s education through the Canada Education Savings Grant (CESG). The basic CESG equals 20% of contributions you make, to a maximum of $500 per beneficiary per year ($7,200 lifetime). That’s like earning 20% on a $2,500 contribution, off the top.

Are you and your spouse in different tax brackets? If so, think about opening a spousal RRSP which will enable you to split future retirement income, potentially saving you tax as a couple later in life.

If your employer matches your pension contributions dollar-for-dollar, choosing to pay down debt instead of contributing could mean missing out on what’s essentially an opportunity to double your money.

Consider a balanced approach

No matter if you’re leaning toward investing or trimming your debt, the good news is either path can add to your wealth. Rather than choose between them, sometimes the pragmatic solution is to take a balanced approach and do both. That way you get the benefits of each.

How? Use the tax refunds produced by your RRSP contributions to reduce your loan balance. Or, if your TFSA savings are well ahead of goal, look at applying some of the profits against your mortgage. And, if you’re able to put a lump sum against your debt and cut the size of your payments, consider directing those new-found savings to an automatic investment purchase plan and steadily build your portfolio every month.

Get the right advice

The decision of whether to pay off debt, invest, or do a little of both, has its fair share of trade-offs. That’s where your Westminster Savings financial planner can help. We’ll sit down with you and clearly explain all of your options, with your circumstances and goals in mind.

At Westminster Savings, we'll help you create an investment strategy that evolves as your life does, and keeps the focus on your goals – not on the things you can't control.

Call us at 604-517-0100 or send us your question online and we'll respond to you within one business day.

*The information contained in this newsletter was obtained from sources believed to be reliable; however, we cannot guarantee that it is accurate or complete and it should not be considered personal taxation advice. We are not tax advisors and we recommend that clients seek independent advice from a professional advisor on tax related matters. Using borrowed money to finance the purchase of securities involves greater risk than purchasing using cash resources only. If you borrow money to purchase securities, your responsibility to repay the loan and pay interest as required by its terms remains the same even if the value of the securities purchased declines. Mutual funds are offered through Credential Asset Management Inc. Mutual funds and other securities are offered through Credential Securities Inc. Credential Securities Inc. is a Member of the Canadian Investor Protection Fund.


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