From time to time, people find themselves with a little extra cash. This happens for a number of reasons. Potential sources include disciplined saving, three-pay-period months, gifts, inheritances, or tax refunds. Friends, family members, clients, and acquaintances often ask me what they should do in such situations. We all know that there are plenty of options. This blog focuses on what is often a first step in deciding where to direct money in such situations – saving/investing the money, versus using it to pay off debt. Here are a few things to consider when making that decision:
1) Know your personal tolerance for carrying debt
If you are uncomfortable being in debt, then the decision is simple. Don’t bother comparing the potential after-tax rate of return inherent in your options – just pay off your debt. Doing so is a risk-free way of improving your finances. Even though it may not be the optimal choice for your overall financial plan, carrying debt that you are not comfortable with is not worth losing sleep over.
2) Rate of return
The next thing you should consider is the rate of return that your investments/alternatives might earn you, versus the interest rate that your debt carries. Different types of investments offer different rates of return, and different forms of debt carry wildly different interest rates. Consider the difference between a secured line of credit (with ‘typical’ interest rates of less than 4% these days) and credit card debt (which often carries interest rates in excess of 19%). Your ultimate goal should be to compare the rate of return on your prospective investment(s) to the interest rate on your debt, and put your money towards whichever is higher.
Shifting our focus to income tax, it is important to note that, once again, not all forms of savings/investments and/or debt are created equal. There are taxable investment accounts (which include RRSPs, as RRSP withdrawals are eventually taxed), and tax free savings accounts (TFSAs). Conversely, there are types of debt that carry non-deductible interest (such as unaltered mortgages and credit card debt), and there are types of debt where the interest payments are tax-deductible (such as mortgages and/or lines of credit, which have been drawn upon for the purpose of investing their proceeds).
For example, if you are considering an investment in a balanced portfolio, it may be reasonable (depending on market conditions) to expect a 6% rate of return. Moreover, if your only source of debt is your mortgage, which carries of an interest rate of 3%, the decision might seem obvious – investing is better than paying down your debt. Hold on though – this analysis is not complete. We have yet to consider income taxes. Let’s say you have already maxed-out your tax free savings account, and thus, any incremental investments you make are taxable at a (your) marginal tax rate of, say, 40% (which is relatively low these days). Well, that means the real rate of return on your taxable investments is not 6%. Rather, it is 6% less 40% of income tax, which leaves you with only 3.6% (6% x (1 – 40%)) after-tax. That is a much smaller difference between the anticipated benefit of investing, versus that of paying down your mortgage . Moreover, it is important to note that the return on one’s balanced portfolio is by no means guaranteed. In other words, history might suggest a 6% pre-tax rate of return; however, we all know that markets can go up or down, especially in the short run. Paying down debt, on the other hand, gives a guaranteed rate of return. As such, in this case, you would be deciding between a guaranteed rate of return of 3%, and a prospective after-tax rate of return of 3.6%. Not an easy decision!
Obviously, in cases of high-interest debt, the decision is clear – pay it down! You would be hard pressed to out-perform the notional pre-tax rate of return inherent in paying off credit card debt (recall that the interest rate on credit card debt can be more than 19% and, moreover, such interest is not tax deductible). You won’t find an investment that guarantees an after-tax rate of return like that.
The decision of whether one should save versus paying off debt is, like most financial decisions, dependent on one’s personal facts and circumstances. The numbers are rarely as concrete as described above, so it’s a good idea to seek a professional who can help you not only crunch the numbers, but also analyze your overall situation.
Personable and professional, Brent Soucie specializes in cross-border tax and financial planning for U.S. citizens and/or Green Card holders residing in Canada, as well as Canadian residents with U.S. employment and/or property. His clients include professional athletes, entrepreneurs, and corporate executives.
Last year, I authored a blog on the benefits and drawbacks of carrying a mortgage into retirement. Included in this blog is a discussion on how to make your mortgage tax deductible.