Pay down debt or invest?

Developing a financial plan is an excellent way to gain a comprehensive understanding of your financial picture. At the very least, you need answers to the above questions in order to make an informed decision about the future of your available cash.

Jim Yih, a financial educator and founder of RetireHappy.ca, says that every decision about money has a logical and an emotional/psychological component.

For the debt reduction or investing scenario, the logical component is calculating which option should yield the better return. There are numerous online tools to help with this task. For example, the Pay down debt or invest calculator available at the Ontario Securities Commission's consumer website, GetSmarterAboutMoney.ca, calculates the "break-even rate." This is the after-tax return that invested money must earn to match the return from using the money to pay down debt. If the investment return is no better than this rate, it's normally better to pay down debt.

Note that the OSC calculator uses the term loan for debt. If you have more than one type of debt, you should run the calculator for each debt. The calculator requires the following data inputs:

• The loan interest rate;
• The loan compounding period;
• The tax-deductible status of the loan. Only interest on loans used for business or certain investing purposes is tax-deductible. Interest costs for most common forms of debt -- car loans, lines of credit and mortgages -- are not;
• The marginal tax rate on your income. (Visit this link to find your marginal tax rate.) Debt is paid with after-tax dollars, so the real cost is higher than the nominal interest rate. For example, Yih notes that the after-tax cost of a debt at 7% interest is 10.77% for someone in the 35% marginal tax bracket;
• The marginal tax rate you expect to pay on the investment profits. If the money is invested in a tax-free investment such as a TFSA, or an investment which taxes returns only on withdrawal, such as an RRSP, RESP or RDSP, this rate would be zero.

To illustrate how the calculator can help with financial decision-making, let's consider the case of Mary, who has just received a $10,000 inheritance from her aunt's estate. Mary's debts include a $10,000 line of credit used for home improvements (6% interest rate, compounded monthly) and a $150,000 mortgage at 3% interest rate with semi-annual compounding. What should Mary do with her inheritance: pay down debt, or invest the money in her RRSP? Her marginal tax rate is 30%.

The standard rule of thumb is to pay off your highest interest debt first, in this case Mary's line of credit. According to the calculator, the RRSP would need to earn 6.2% to match the return from reducing this debt. If the RRSP earns less than this figure, paying off the line of credit is the better choice.

In our current low-rate environment, with most five-year GICs yielding less than 2%, investments with guaranteed returns will not earn 6.2%. Only those without guaranteed returns, such as stocks, have the potential to earn 6.2% or more. Since paying down debt provides a sure return, Mary decides to pay off her line of credit.

If Mary's only debt was a mortgage, an RRSP return of just 3.02% would match her return from paying down her mortgage. She decides that investing her inheritance is the way to go. However, compared to paying down debt, the decision is more complicated. What investments should she buy? What range of returns can she expect? How long will the money be invested? How much investment risk is she willing to assume?

To answer such questions, the psychological/emotional factors that affect any decision to pay down debt or invest need to be considered. "When it comes to money, psychology is always more powerful than logic," asserts Jim Yih.

Are you over-confident about your investment ability, or the investment return you expect to earn? Are you too optimistic about being able to pay off debt at some future time? Are you so risk-averse you invest only in GICs, a money-losing proposition after inflation?

"We self-rationalize debt as a good thing when interest rates are low," says Yih. "In fact, a low interest-rate environment is the best time to pay off debt because more of your money goes toward paying off the principal, not the interest cost."

A strong advocate of debt reduction over investing is Kerry Taylor, who runs the financial blog SquawkFox.com. "I am a pay-down-debt person all the time," she says. "If you pay down debt, you free up cash flow and reduce the psychological weight of carrying debt."

Paying down debt is the way to go if, after thoroughly examining your choices, you are still undecided. It's the right choice for those who are close to retirement and still carrying debt. If your financial advisor recommends that you invest, and not pay down debt, it could be due to a conflict of interest: he or she will benefit only if you invest the money.

Kyle Prevost, a high school teacher and co-founder of YoungandThrifty.ca, says that paying off high-interest debt such as credit-card debt is the first priority. After that, he believes that the right decision, be it debt reduction or investing, is based on psychology: Which choice will motivate you to stick to your financial plan?