Your amount and type of debt, years to retirement and expected investment return are all factors to consider.
So, you’ve managed to save a little money, or have recently come into some money. As you decide how to best use this money, your credit card and/or mortgage bill comes in. You now need to make what feels like a big decision—should you use this money to pay down debt, or should you invest it and watch it grow?
It’s a choice many people struggle with, especially as the RRSP deadline approaches and Canadian savings habits—or lack thereof—dominate the news.
Interest rate vs. investment return
The easiest way to make this decision is to compare the interest rate on your debt with the expected return on your investment. As a general rule, you should put your money towards whichever rate is higher.
For example, let’s say you must decide between paying down your mortgage (with a five per cent interest rate) or contributing to your RRSP (with an average seven per cent return). Based on the simple math, the growth you would see in your investments would out-pace the savings you’d make on your mortgage by about two per cent. After a few years, the difference could be significant.
On the other hand, if you’re deciding between paying down your credit card (with a 19 per cent interest rate) or contributing to your RRSP, you should pay down that card. That 19 per cent interest rate should be your priority.
Investing and paying down debt simultaneously doesn’t work
Whether you decide to pay down debt or invest, be sure to stick with your decision. Contrary to popular belief, the “little of both” solution actually makes little sense. This is because, if investing is the best decision for you in February, then it’s likely still the best decision for you in April when that juicy tax refund lands in your mailbox. Reinvest that tax refund and continue to earn that two per cent advantage.
Alternatively, if you decide to switch gears and use that tax refund to pay down your mortgage, you are hindering your maximum investment gains. It’s kind of like driving the quickest route to work Monday through Thursday, then deciding to take a longer route on Friday.
Investing your money or paying down debt is an important decision, and your amount of debt, type of debt, years to retirement, and expected investment return are all factors to consider. We have presented a relatively simple formula in making this decision, but if your situation is a bit more complicated, our ATB experts can provide you with some advice to help you create your own plan.
Interesting fact: 38% of Albertans said if they received a tax refund for 2015 they would use it to pay down debt. 37% would put it into savings or investments. Source: ATB Investor Beat, April 2016