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Pay off debt or invest? 8 factors you should consider

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To pay back debt or invest. That’s the question. And it’s top of mind for many Canadians now more than ever.

Between historically-low interest rates, lockdowns driving a sharp decline in consumer spending, and online brokerages continuing to make investing easier, Canadians who are sitting on some extra cash are reevaluating their finances.

While you can invest and pay debt simultaneously, depending on the type of debt you owe, you’ll want to prioritize more of your effort (and money) towards one over the other. Below are eight important factors to help you decide which path to take.

1. Have some kind of emergency fund

Before deciding whether to pay off debt or invest, we would argue a crucial first step is to build up an emergency fund.

With a stash of cash set aside (ideally earning interest in a high-yield savings account), you’ll have a financial buffer and be better prepared to face life’s unwelcome surprises, like a sudden drop in income or urgent home repair. An emergency fund can help you avoid digging yourself further into debt or having to suddenly sell off your investments when the volatile stock market is in the middle of a dip.

The exact size of the ideal emergency fund is debatable, with three-to-six month’s worth of expenses being the most cited. But if you currently owe consumer debt, having any amount of cash on the sidelines to be used only in case of emergencies is a good move.

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You can build an emergency fund gradually by setting up automated transfers from your chequing account to your savings account every payday, or all at once if you receive a windfall. Just remember, while building your emergency fund, you must continue to make at least the minimum payments on all your ongoing debts.

2. Understand the difference between good and bad debt

Good debt exists? It sounds like an oxymoron, like good cholesterol, but it’s a real thing in both cases.

Good debt refers to any type of loan where money is borrowed to purchase an asset that can increase in value. A mortgage is the archetypal example of good debt since home values appreciate over time and interest rates are often in the low-to-mid single digits.

Carrying good debt while simultaneously investing in the stock market can be a great move and help to diversify your assets, build up your net worth, and give your retirement nest egg a boost.

Bad debt involves any loan where money is borrowed to purchase a depreciating asset or cover an expense, and will always serve to eat into your investment returns and hurt your ROI. Credit card debt is considered bad debt since you’re using borrowed money at a high-interest rate to cover day-to-day purchases (like groceries or a cup of coffee). Car loans are also considered bad debt.

Some debts fall into a grey area between good and bad. For instance, some argue student loans is good debt since you’re investing in your education and future earning potential while others believe it’s a spectrum and a case of bad versus worse debt.

3. The critical role of interest rates

Good and bad debt aside, the interest rate on the loan you owe is hugely important too. The higher the interest rate, the more expensive the debt, and the bigger the priority should be to pay it off versus invest.

Interest rates on personal loans and unsecured debt (like credit cards) can vary anywhere from 2% up to 20.99%, or higher. As a general rule of thumb, you should almost focus on putting most of your cash towards paying down high interest debt when rates start hovering close to the double digits.

Credit card debt is a lethal combination of both bad and high-interest debt, and focussing your efforts on paying off your balance is almost always the better financial move. It comes down to hard numbers. Most credit cards charge annual interest rates of around 19.99%, meanwhile, historic stock market returns hover around 7% to 10% on an annualized basis. In other words, you’re losing more to credit card interest than you’re gaining in investment returns.

A popular and effective strategy to speed up your credit card debt repayment involves using a balance transfer to move your existing balance from a high-interest card to a lower interest alternative. When paying for new purchases, it’s also always best to stick to a budget and pay off your monthly credit card balance in full to avoid owing any interest at all. And if achieving that is tough, consider sticking to a low interest card (some of which charge half the interest rate of a conventional credit card).

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When a loan carries a low interest rate (5% or below), it’s considered cheap debt and there’s an argument for investing instead of paying off the debt immediately. The idea being, with such low rates, you can earn higher returns investing than you’ll owe in interest.

The flaw to this logic is that stock market performance isn’t consistent, and can fluctuate day-to-day or even fall into the negatives in the short-term. As a rule of thumb, the longer you’re invested in the market, the higher the likelihood you’ll see steady returns. So if you’re only investing for a few months or just one year, you’ll open up yourself to more risk. Additionally, interest rates on loans aren’t always guaranteed and terms of the debt can be subject to change (for example, an increase in the bank’s prime rate can have a knock-on effect on your monthly payments).

4. Investment approach and risk tolerance

While the hard numbers are important, acknowledging your personal investment goals, approach, and risk tolerance is critical too.

Yes, logically, a low interest loan with a rate below 5% is considered cheap debt and you can theoretically earn higher returns on the stock market. But what’s your risk tolerance? Will you be able to stomach day-to-day drops in the market when interest payments are looming, or are you sensitive to market fluctuations and will you react emotionally by selling off your portfolio due to a short-term dip?

While deciding to invest instead of paying off debt is an easy decision in a bull market when portfolio values are only going up, it’s a whole different story when share values drop (and that can and does happen, often spontaneously). If you’ve never experienced a market sell-off first hand before, you might want to be cautious. Choosing to invest over paying debt is often better suited for the seasoned investor who’s had some skin in the game. Remember, stock market returns usually aren’t instant and you’ll need to be consistently investing for a few years in order to earn steady returns.

Your preferred type of investment is also important. For instance, it makes little sense to prioritize investing over paying debts if you’re heavily bought into conservative products like GICs or fixed income since returns likely won’t outpace interest rates. Equities like index funds and a well-diversified portfolio of stocks, on the other hand, can earn returns of between 7% to 10% (or more) on an annualized basis over longer periods of several years.

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5. The size of the debt

The size of the debt you owe is another factor to consider as it can have a direct impact on your credit rating, and therefore, your ability to secure lower interest rates on loans in the future.

Credit utilization is a major credit score factor and measures your debt load in proportion to your overall available credit limit. As a simplified example, if you’ve got only one credit card with a $1,000 limit and you owe $500 in debt, your credit utilization ratio is 50%. As a rule of thumb, your credit utilization ratio should ideally be below 30%.

If you carry a large proportion of consumer debt relative to your overall net worth or total credit limits, using more of your money to tackle the debt can be beneficial (regardless of the interest rate) as it could lead to a significant boost to your credit rating.

6. Your relationship with debt

How did you end up with debt in the first place? Do you owe multiple loans? Do you have a history of racking up consumer debt due to overspending? All these are critical questions to ask yourself as they can help inform your spending habits, budgets, and how prone you are to falling into cycles of bad debt.

How you view debt is important too. Are you comfortable with the idea of owing debt or do you consider it a burden that’ll weigh you down?

7. Investing for retirement always has a place

While tackling bad high-interest debt – like credit cards or pay-day loans – should always be the priority, there’s also plenty of grey area and you should strive to both pay debt and invest to at least some degree.

For instance, if you do owe a high-interest car loan, continuing to set aside a small amount of money towards retirement (even if it’s $10 every month with a robo-advisor) can be a good move. This way, you can allocate most of your money towards crushing your debt while still contributing a small amount towards your retirement bucket. Meanwhile, if your employer offers a Group RRSP plan with matching, simultaneously investing while also paying down your student loans can be a prudent decision considering you’re effectively getting “free money” to invest and could potentially end up with a bigger tax refund.

8. Have a plan either way

Going in blind is never a smart decision.

If you want to hold off investing until you pay off your debts, you’ll need to create an action plan, budget, and timeline outlining exactly how you plan on eliminating your loans. You may want to consider strategies like debt consolidation, cutting back on everyday spending, and using the debt avalanche method. Otherwise, you’ll lose a lot of money and time you could’ve spent investing and earning compounding returns.

If you plan to juggle both investments and loans, be sure to closely monitor your investments’ performance, have a clear time horizon (how long you plan to invest for), avoid day trading, and ensure the math really works out in your favour. Also, don’t forget to stay on top of your minimum payments, keep track of your debt’s interest rates, and get familiar with your loans’ terms and conditions to ensure you’re aware of any possible changes in rates or repayment rules down the line.

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