Feb 14, 2023
Extra cash can present a dilemma – is it better to pay down your debt or put the money to work in investments? Either choice can make sense and the best course of action will depend on the circumstances.
As a general rule, if the return you can earn investing your money is greater than the interest your debt is costing you, then it makes sense to invest.
In order to compare the two options, you first need to establish what debt you’d be paying down and what the plan would be if the cash is invested.
If paying down your debt, priority should be given to debt charging the highest interest rate.
If the cash is to be invested, it should be done according to your financial objectives and risk tolerance.
There are complicating factors that can influence this decision and need to be considered – 4 common instances are listed below:
1. The impact of income tax on investment returns
It’s important to use your after-tax return when comparing investing to the cost of borrowing. This is illustrated in the example below:
Investor’s After-Tax Return = (GIC interest rate) x (1 – investor’s marginal income rate) = (5.00%) x (1 – 40%) = 3.00%
2. The emotional weight of debt
If you’re losing sleep over your debts, then you’re likely better off paying them down even if you could earn a higher return from investing.
3. Your risk tolerance
Investments with expected returns that exceed the cost of borrowing will often be market based. The volatility and uncertainty that go hand-in-hand with these investments need to fit within your risk tolerance.
4. The benefit of tax deductions and government grants
Investing your cash may yield additional benefits such as tax deductions (e.g., RRSP, FHSA contributions) or government grants (e.g., RESP, RDSP matching).
The decision to pay down debt or invest is made using the information available to you at the time. In March 2022, the BoC started raising the policy interest rate quickly and forcefully to combat inflation. This has prompted financial institutions to increase their prime rate (baseline rate for lending) from 2.45% to 6.70% (as of January 2023).
This seismic shift in rates highlights the importance of ongoing planning and the need to review and adjust your strategy to reflect changes in both your circumstances and the economic environment.
At historically low interest rates, it may have made sense for an individual to invest extra cash instead of making optional payments on their variable rate mortgage. Now that variable mortgage rates are in the range of 6%, it may now be prudent to shift their focus to debt repayment.
Conversely, an investor opting to make additional payments on a 2.25% fixed rate mortgage may now be better served directing that cash flow into their investments.