March 25, 2014, 7:31 am

Extra Money – Should I Pay my Debts or Start Saving?

by: The Financial Blogger    Category: Pay off your Debts
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Last week, I started an interesting discussion with my post about making more money instead of cutting from my budget. After debating the point of cutting my expenses or making more money, I chose the latter and started to make some real progress on my balance sheet. But I’m not using all my extra money to pay off debts. I also use my extra money to save more money.

 

I STILL HAVE DEBTS, AND I SAVE MONEY ON THE SIDE, SAY WHAT?

 

For some people, being debt free is their main goal and they will reach it at all costs. They actually think it’s the best way to save money and become financially free. I definitely don’t agree with this. The choice of saving money or paying off your debts should be more mathematical than psychological.

 

Two years ago, I made a personal commitment to take care of my debts. While I didn’t achieve my aggressive repayment goal, I’m still in a better position today than I was two years ago. During the same period, I also manage to save up $7,362 for my children’s education and added $10,000 to my RRSP account.

 

It is true that I could have used this $17K to pay off my debts and I would have been able to complete my debt repayment plan. But I feel a lot better about my current balance sheet. Here’s why.

 

THE TAX IMPLICATION OF SAVING VS PAYING OF DEBTS

 

As I live in the beautiful country of Canada, I’m blessed with one of the highest marginal tax rates in the world. But this also comes with generous tax advantages for retirement savings and subsidies for education investment plans.

 

The first reason why I decided to save money instead of paying off my debt was the immediate tax impact on my investment vs the low interest rate paid on my debt. For example, I saved 45% in tax (my marginal tax rate) on my $10,000 RRSP contribution. This equals $4,500 in taxes saved. Then, I received a 30% subsidy on my RESP contribution. This subsidy is directly invested along with my money and will be taxed in my children’s hands upon withdrawal.

 

INVESTMENT RETURNS VS INTEREST RATE DEBT

 

The second reason why I decided to invest part of my extra cash instead of increasing my debt repayment was the fact that my potential investment return is higher than the interest rate paid. Last year alone, my dividend stocks made 22% (including dividends received) while my highest interest rate is 6.5% on the loan for my pool (I know, what a shame to have a pool loan!).

 

If you are unsure about whether you should pay off your debts or save more money, a good trick is to list how much you make in investment return vs how much you pay in interest. If you are a conservative investor and yield 2-3% per year, there is no point for you to keep this money invested if you have consumer debts. But if you are invested more than 50% in the stock market and pay a low interest rate, you should keep investing.

 

The power of compounding interest will work its magic on my investments while it doesn’t apply on a loan. Take $10,000 invested at 5% vs a $10,000 debt at 5%. During the first year, the $10,000 invested will generate $500 (5%). But the second year, you are now at $10,500 invested at 5%. Therefore, you will earn $525 (5% of $10500), not $500. The extra $25 on your gain will continue to grow year after year. This is the magic of a compounding interest rate.

 

On the other hand, if you have a $10,000 debt and pay $500 of interest during year 1, you will still have to pay $500 in interest in year two. The interest doesn’t compound on a debt. This is why it’s almost always better to invest than pay off your debts even if the interest rate / investment yield are the same (assuming there are no taxes on your investment).

 

WHAT WILL I DO WITH MY NEXT PAY RAISE?

 

In June, I should get a small pay raise. Since I’m already making a good income, my pay raise should just about match inflation. This should be around 2% this year. But 2% of 80K is better than a slap in the face, right? This will result in about $60 gross on my pay check. Technically, I should get about $25 net in my pocket. Not the end of the world, but this will help my goal of increasing my TFSA contribution to $150 bi-weekly. Regardless the amount of my pay check raise, it will go directly in my TFSA.

 

I still believe I will be making more money with my TFSA that what it cost me in interest. And if it’s not the case, I will always be able to cash in my investments and pay off my debts at anytime. This gives me more flexibility than being debt free and borrowing in the future to fund my kids’ private college.

 

HOW WILL I PAY OFF MY DEBTS THEN?

 

If I use my extra cash to fund my children’s education and retirement plan, this doesn’t leave much room for debt repayment, right? This is where the budget comes into place! I already put a monthly payment down on my debts. Then, I will cash my employer stocks (which are already at $5,000 right now), use my tax return (another $2,000 or so), some dividends from my company (we started to pay ourselves again!) and year-end bonus (calculated based on what I already earned, very conservative).

 

I do some calculations on a monthly basis to make sure I’m still on track for this aggressive plan and so far, I’m right on track! This will be an amazing year: vacations + debts pay off!

 

How about you, do you focus on yours debt or your savings?

 

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Comments

If you have no clear preference and have positive reasons for each strategy, why not do both to start off? Splitting between saving and paying down debt is going to result in a positive impact to your net worth either way, and what often happens is that you find that one stands out above the other, in which case you can certainly choose to adjust your strategy.

by: The Financial Blogger | March 25th, 2014 (7:54 am)

I’d say that I’ve always had a preference on invesing ;-). So far, it has paid off big time. The market has been good for me for the past few years so it’s always tempting to invest instead of paying off my debts. The thing is that my investments are used for retirement and kid education (so I can’t take it when I want to pay off my debts).

Now that I have extra income coming in, I’ll be able to do both :-)

I would say that the peace of mind from having no debt would be more valuable. Once it’s gone, it’s gone, assuming you don’t add to it. There’s also the wild card of unexpected life events, which could affect your income earning abilities. If you have no debt, one less thing to worry about. All my humble opinion, of course, thanks for the post.