This is a question that I get asked on a regular basis. While regular monthly contributions to a Tax Free Savings Account (TFSA) or a Registered Retirement Savings Plan (RRSP) typically make sense, those carrying high interest debt loads will usually be advised to put that extra cash flow against their debts instead.
Every situation is different but most of the potential investors in this position will never earn enough investment returns to offset the interest accruing on their debt.
Let me explain – the average investment account in Canada (based on historical returns of the Canadian stock market index) earns somewhere around seven or eight per cent per year. Unless these investments are held in a TFSA, this growth is also taxable which will leave you an after-tax return of around two per cent less.
At the same time, balances held on a credit card are accruing interest at an average rate of anywhere from 10-20 per cent per year. You can easily see why this plan doesn’t make any sense and how much more effective it would be to pay off that credit card debt first and then start your investments back up after it’s gone.
Let’s look at this in another way – If you invest $1,000 per year and earn a seven per cent return, you earned $70 of taxable growth that year. If you were to take that $1,000 and put it against credit card debt that is running at a 19 per cent interest rate, you would save $190 worth of interest charges. That means you come out $120 (or 12 per cent) farther ahead and you don’t have to take on any investment market risk to get there.
You really can’t argue against this basic math but having said that, there are some cases where continuing to invest actually does make sense. So what are they?
1) The first scenario is for those that are lucky enough to have employer matched contributions to a defined contribution pension or group RRSP. If you were to invest $200 per month and your employer kicks in another $200 on your behalf, you’re already earning a 100 per cent return on your money. Add the seven per cent per year of investment growth and this means that you are earning a 107 per cent annual return which significantly outweighs the 10-20 per cent interest costs you have to pay.
2) Not all debt is created equal and if you only have “good debt”, you may be better off continuing to invest. The high interest debt I’m talking about above falls into the “bad debt” category but a low interest line of credit or mortgage may not. In this situation, you may be better off to pay down the low interest loan and invest at the same time. A proper financial plan can help you to determine what makes the most sense in your case.
Unless your situation falls into one of the two examples above, there really is no logical argument to be made for continuing to invest until your credit cards and other “bad debts” are paid off.
If you find yourself holding debt on a card or through another high interest loan, take the time to sit down with a Certified Financial Planner professional to discuss your options and make a plan to clear off that debt and get back on the road to financial freedom.
This column is written by Michelle Weisheit CFP, IG Wealth Management and presents general information only and is not a solicitation to buy or sell any investments. Please contact your own advisor for specific advice about your situation.