Since approximately 2009, interest rates have been at rock bottom, while most rates are only about 2-3% whether to pay off debt or invest is not that significant. However, in the last year, interest rates have spiked upwards, and now this trade-off is far more important. Before diving in, it’s important to note that choosing whether to invest or pay off debt is really a question of what you should do with additional savings – which is a good problem to have. You’re meeting all of your expenses and are capable of saving money, trying to find the optimal solution for your savings. Also, it’s important to have an emergency fund. Have some money set aside that you can draw on during rough times. Ideally, you want an emergency fund that has 3-6 months of your living expenses. With the emergency fund intact, here are a few factors to help you decide whether to invest your money or pay off debt. This is the first type of debt: there is a difference between having a mortgage on a home and credit card debt from a vacation.
Over time, the value of your property will likely increase – it appreciates. A mortgage still needs to be dealt with, but seeing as you have an appreciation asset, there’s a difference between debt for appreciating assets and debt for consumer goods, such as vacations or clothes. Related to this is secured and unsecured debt. If your debt is backed by something, like an asset, such as a house or land, it’s known as secure debt. Personal lines of credit or credit cards are examples of unsecured debt. Typically, folks use unsecured debt to buy consumer goods or assets that depreciate. Unsecured debt is typically more expensive and subsequently has higher rates. As a general rule, the more unsecured debt you have or debt for depreciating assets, the quicker you want to pay it off in full. Usually, in most cases, paying off this debt is better than investing. Another key factor is the amount of debt you have. There is a term we use called “credit utilization”, which is a key factor in your credit score and is something the majority of banks and credit unions look at when determining whether you qualify for a mortgage. To put it simply, credit utilization measures your debt load compared to your overall available credit. If your car breaks down and you need a new one, you may find it hard getting a loan if you are already in a lot of debt. The less debt you have, the more flexibility you have in the end. The next factor to consider is arguably the most important factor: interest rate. The higher the rate you pay on debt, the more incentive you have to pay it off. Often folks compare their rates. I got 7% on my investments the last few years and my mortgage rate is at 5%, investments in this case are better. There is some validity to that math, but an essential part of the equation that’s missing is risk. Paying off debt is very low risk, you’re aware of the outcome, and the interest rate is stated, and you’re using after-tax dollars. So, paying off debt is much like a guaranteed after-tax return. Apart from the TFSA, most investment gains have some sort of tax involved. Also, investments vary in risk. If you are a more conservative person, the low risk option is to pay off debt. If you’re comfortable with a medium level of risk, I think a 6% threshold is a decent rule of this sort of environment. Debt with rates above 6% put extra funds into paying that off, and below 6%, extra funds to investing. There isn’t a one-size fits all approach when it comes to debt and investing. Chat with your financial professional so they can help you determine what makes the most sense for your financial situation. CG WEALTH MANAGEMENT IS A DIVISION OF CANACCORD GENUITY CORP., MEMBER-CANADIAN INVESTOR PROTECTION FUND AND THE INVESTMENT INDUSTRY REGULATORY ORGANIZATION OF CANADA The comments and opinions expressed in this article are solely the work of Clinton Orr, not an official publication of CG Corp., and may differ from the opinion of CG Corp’s. Research Department. Accordingly, they should not be considered as representative of CG Corp’s. beliefs, opinions or recommendations. All information is given as of the date appearing in this article, is for general information only, does not constitute legal or tax advice, and the author Clinton Orr does not assume any obligation to update it or to advise on further developments related. All information included herein has been compiled from sources believed to be reliable, but its accuracy and completeness is not guaranteed, nor in providing it do the author or CG Corp. assume any liability. Tax & Estate advice offered through CG Wealth & Estate Planning https://advisorweb.cgf.com/content/uploads/sites/67/Financial-Focus-May-2023.pdf Comments are closed.
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AuthorClinton Orr is a Senior Wealth Advisor and Senior Portfolio Manager with Canaccord Genuity Corp. Archives
July 2023
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