Home > Personal Finance > Debt is NOT a four-letter word

Debt is NOT a four-letter word

I’m a finance guy. It’s a big part of what I do and it’s also fairly common knowledge in even my extended social circle. So I guess it should come as no surprise that I’m often asked for advice when it comes to matters of dollars and cents. It just comes with the territory, and I’m always willing to spend a little time educating people on personal finance and taxes.  I use the term “educate” specifically because the first thing I generally tell people is not to take anyone’s advice. I tell them that it’s important to educate yourself and that what’s right for your friend, or your brother-in-law or your office-mate may not be right for you.  Generally in a conversation, it’s hard to demonstrate exactly how true that is, so I decided to illustrate that point with an example that debunks some generally held beliefs about savings and debt.

The setup

Kelly from Toronto is pretty good with his money. He doesn’t carry a balance on his credit card, lives within his means, and his only debt is a $1,000 line of credit (8.5% APR). He’s got a little bit of money at the end of every month and he’s trying to decide what to do with it.  He’s getting all kinds of advice but he decides to ask his especially handsome friend Michael to help him decide what to do. Michael doesn’t want to give Kelly advice so he decides to walk him through a couple options and let him decide for himself. Let’s see what they come up with.

Option #1 – Payoff his line of credit

If Kelly pays $87.22 per month towards the balance on his line of credit, he’ll have it completely paid off in one year. In that year, he’ll have paid $46.63 in interest vs the $85 he would have paid in interest had he not paid off the LOC.

Net Gain: $85 – $46.63 = $38.37

Net Worth (all things being equal): $0 (nothing owed and nothing saved)

Michael lets Kelly know that this is a very safe option. It helps his liquidity in the short term and increases his overall net worth from -$1,000 to $0.

Option #2 – Save for a rainy day

If Kelly takes that same $87.22 per month and puts it into a savings account for 12 months he’ll earn about $52 in interest (this is a generous estimate). He’ll also have paid $85 in interest on his still outstanding LOC.

Net Loss: $52 – $85 = $33

Net Worth (all things being equal): $0 ($1,000 owed and ~$1,000 saved)

Michael lets Kelly know that this is also a very safe option. While he’s actually losing a little bit of money by not paying off his debt, he’s accumulated a nice bit of cash (something everyone should have). If times get tough or Kelly loses his job, he’ll have his $1,000 to be able to pay bills etc.

Option #3 – RRSP contribution (For those in the US, an RRSP is very similar to a 401k)

If Kelly takes his $87.22 per month and contributes it to a RRSP for 12 months and we assume Kelly’s income tax rate is 35%, he’ll receive a tax credit of about $366. Like the previous example, he’ll have also paid $85 in interest on his LOC.

Net Gain: $366 – $85 = $281*

Net Worth (all things being equal): $0 ($1,000 owed and ~$1,000 saved)

*Does not include the potential to gain income over the life of the investment

Michael advises Kelly that this is a long-term play. It makes him less liquid now, but any amount he can save for the future at this young age will maximize the potential growth of that investment. He also defers some tax liability to his retirement age when he’ll conceivably be at a much lower tax rate.

Option #4 – Borrow MORE money (what?!)

In addition to the RRSP contribution made in Option #3, Michael advises that Kelly could also take out an RRSP loan to get an even bigger tax credit. Most Canadian bank offer “RRSP Loans” to clients at extremely low interest rates in order for them to be able to make the biggest contribution possible to retirement savings accounts. If Kelly takes out an RRSP loan for $1,000 at 3%APR and adds that money to his RRSP contribution for the year his combined tax credit will be about $716. He’ll have paid $85 in interest on his original LOC and will also be responsible for $30 in interest on his new RRSP loan.

Net Gain: $716 – $85 – $30 = $601*

Net Worth (all things being equal): $0 ($2,000 owed and ~$2,000 saved)

*Does not include the potential to gain income over the life of the investment

Michael advises Kelly that this is the least liquid, and most risky of the four options he’s presented.  It’s risky because it puts Kelly at risk should he lose his job, or have any type of financial crisis in the short term of not being able to meet his debt obligation. Conversely, it also provides the highest net gain of the four options.

So, after all of that, which is the best strategy? As I’m sure you’ve guessed, there is no “best” answer, only a “what’s best FOR YOU” answer. What’s best for Kelly (or you) is going to depend on a variety of factors including:

  • Tolerance for Risk
  • Needs (short term vs long term)
  • Certainty (liquidity vs not)

The options presented above are by no means the only options available either. If you have a mortgage (and are allowed) making one-time payments directly to your principle can dramatically reduce the interest you’ll pay over the life of your mortgage.

Educate yourself to the best of your ability on your situation, your needs, and your options, and it will become evident which strategy (or combination of strategies) make the most sense for you.

Wait, I guess that sounds a bit like advice doesn’t it?

Categories: Personal Finance
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