Imagine you find yourself in the following situation: you have a $10,000 home equity line of credit at 3.00% interest to pay off, and you recently received a $40,000 inheritance.
What to do? There’s certainly a temptation to just pay off the debt in one go, but that will reduce your investment capital substantially. On the other hand, paying down your debt is important as it will save you money in interest payments, improve your financial situation and offer you peace of mind.
There is a middle ground, however. It involves investing the inheritance to help you pay down your debt.
Before we take a look at how this could work, let’s make a few assumptions. First, we’ll assume that your goal is to save $2,000 every year. Second, let’s also assume that you are already able to service your line of credit (meaning pay the interest), so you are able to use any annual savings to pay down your debt.
On the investment front, let’s assume that you intend to open up a TFSA and invest your inheritance in GICs and equities. This means that all income will be tax-free. The GICs you’re looking at will yield 1.5% and the equities you intend to purchase have an average dividend yield of 3.00%. To accelerate your debt repayment, you decide to use all dividend and interest income to pay down your line of credit. Your desired weighting is 70% equities and 30% GICs. For the equity portion, you’re targeting a 7% return over the long term.
Here’s what your TFSA looks like, by asset type and income, once you’ve invested the $40,000 inheritance.
So how would your line of credit look after three years?
After 3 years, the line of credit will almost have been fully paid off. Of course, the bulk of the work is done through the annual $2,000 of savings which are earmarked towards debt repayment. That said, the interest from the GIC and the dividend income contribute an additional $1,020 per year, or $3,060 in total. This has the effect of accelerating the elimination of the line of credit.
There’s one more aspect of this plan to consider: the potential gains in the equity portion of the TFSA. Here’s how the TFSA would look like if the equities rose by 7% for each of the three years:
In addition to the dividends, the capital appreciation of the equities is notable in this scenario. From an initial investment of $28,000, the equities are worth $34,301.20 by the end of year 3 if the market rises by 7% a year.
Some things to keep in mind
If you have the ability to invest, or maintain investments, or pay down debt, you’ll want to consider a few things. First, what’s the interest rate on your debt? The general rule of thumb is that if the after-tax interest you can receive on investment is less than what you’re paying on debt, you should pay back the debt first. Otherwise, you’ll rack up more in ongoing interest expenses than you’re making in investment income. One very useful tool to figure out whether to invest or pay down debt is the free calculator provided by the Ontario Securities Commission.
Second, keep in mind that equity markets can fluctuate wildly. In our example we assumed a 7% annual return, but as everyone knows there are years when the markets can fall, sometimes by double digits. While equities can appreciate in value, your debt repayment plan shouldn’t be reliant on a rising stock market (or dividends, which can always be suspended by companies). That’s why in our case study we had the majority of the line of credit being paid down by savings. Even if the market falls you would still be on the path to debt freedom.
Third, don’t just buy the first GIC you come across. Do your research and get the best GIC rates available. By the magic of compound interest, your principal will grow over time at the highest possible rate.
Finally, remember that by paying off debt, you free up money to invest. All the money you were spending on interest expenses can then go towards RRSP or TFSA contributions. This is why it’s so important to pay off high-interest debt very quickly. If our example had used credit card debt with 20% interest, the better option would definitely have been to pay it off all at once with the inheritance.
Flickr: 401(k) 2012