A lot of dilemmas in personal finance can be, in reality, pretty straightforward.
Should you only make the minimum down payment to buy a house? Should you open an RESP for your kids as soon as possible? Should you put money in risky investments as you approach retirement age?
The answers to those and similarly obvious questions are obvious.
Here’s one, however, where the course of action is anything but clear: Should you put money into your RRSP or pay down your outstanding personal debt?
There are benefits to both actions.
An RRSP gives you a tax break and lets you accumulate returns on investments tax-free.
And paying down debt means you save on interest payments, which can become quite hefty. It also gives you a financial cushion if you or another family member gets hit with an unforeseen problem, like an illness or losing a job.
Drowning in debt
The debate becomes doubly important since Canadians currently carry high levels of debt.
According to RBC Economics, the interest Canadians paid on non-mortgage debt—which is about 30% of total household debt—is equal to what they pay in interest on their home loans.
Equally troubling is Canada’s growing debt levels. In Q4 2017, Canadians owed $1.821 trillion in consumer debt, according to Equifax Canada. That was up from $1.797 trillion in Q3.
No clear-cut answer
Doesn’t that mean you should take your available cash and pay down any debt? Not so fast.
The caveat is that it depends on your individual circumstances.
You might have mostly mortgage debt, for example, which, in the current environment, likely has a low interest rate. And suppose you’re in a high-income tax bracket.
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Then a sound strategy might be to max out your RRSP (just make sure not to go over your RRSP contribution limit) and get a larger tax refund rather than pay off low-interest mortgage debt.
To figure out whether the RRSP route or cutting debt makes more sense, you have to begin by going through a few questions.
Here’s one: What’s the break-even point where the return on investments equals your debt servicing fees?
You should know whether that rate—what you need to make on your investments to cover interest—is realistic. If not, then you might look at putting extra money towards reducing your debt.
The Ontario Securities Commission has an online calculator that helps you to make this comparison.
As an example, if the interest rate on your loan is 5% and the marginal tax rate on your investments is 25%, the site figures a break-even point at 4.43%. That’s what you need to earn on your savings to cover the interest payments on your debt.
If the return is above 4.43% the RRSP idea becomes more attractive. If the return is below 4.43%, debt repayment takes centre stage.
Other factors also come into play in deciding between an RRSP contribution and debt repayment:
Type of debt—Some types of borrowing—mainly installment loans and accumulated credit card balances—have higher attached interest rates than other kinds of debt. So, paying that debt off quicker might be more sensible than paying off your home.
Amount of debt—It’s the same idea as above except here you’re counting how much of each type of borrowing you have. You might consider using extra cash against your plastic if you have a ton of credit card debt; if you have a smallish amount of 0% car debt, cutting that outstanding borrowing isn’t as important.
Your age—Most investment planners have clients close to retirement in conservative investments. That’s because their ability to recover from a large is smaller compared to younger people. But the potential for a lower investment gain also makes debt repayment more sensible for older people. That’s because the break-even calculation—outlined earlier—will likely mean you can’t cover debt payments with investment returns. So debt repayment trumps investing.
Tax rate—The RRSP—with its tax deduction capability—becomes more attractive to people in higher tax brackets. If you’re one of those lucky few, the upfront tax deduction could be more valuable than debt reduction because you can generate a sizeable tax refund with the RRSP.
Type of registered plan—Some companies have group RRSPs in which the employer will match worker contributions. For example, your employer might match every dollar you contribute. As a result, your $1,000 contribution will actually be worth $2,000. That, in turn, could result in the savings contribution becoming more valuable than debt reduction.
The bottom line
It doesn’t mean debt reduction should take a backseat in most circumstances. It probably means you need help from a financial planner to figure this one out.
The decision as to whether to add to your RRSP or cut your borrowing has a lot of moving parts. And getting it right will have long-lasting implications for you and your family’s financial future.
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