Save for Retirement or Clear Your Debt?

Let's look at the cost of money...

Is it better to clear your debts or put money away? Since your net assets equal your gross assets minus your liabilities, you can improve overall financial health by working on either debt or savings.

Information about the different types of investments in the following list will help you determine your priorities, taking into account whether or not the cost of borrowing is deductible.

In the first three tables below, rules for determining priorities are suggested only for situations in which interest on the debt is nondeductible. In these cases, you must choose between paying off the debt or making a deposit in a tax-free savings account (TFSA), a registered retirement savings plan (RRSP), or a registered education savings plan (RESP).

In the fourth table, for unregistered investments, priorities are listed according to whether the interest is deductible.

1. TFSA deposits

Loans with Nondeductible Interest (e.g., home mortgage):

Using your available cash

Priority 1:Create a tax-free savings account (TFSA) cushion (about 6 months' salary).
Priority 2:Pay back your debts if the expected performance is considerably lower than the interest rate. If not, contribute to your TFSA.

2. RRSP contributions

Loans with Nondeductible Interest:

Using your available cash

Priority 1:Create a registered retirement savings plan (RRSP) cushion (about 6 months' salary) if your TFSA contribution room is insufficient.
Priority 2:Pay back your debts if the expected performance is considerably lower than the interest rate. If not, contribute to your RRSP.
Priority 3:Make the minimum payments on your Home Buyers' Plan (HBP) withdrawal and concentrate on new RRSP contributions unless you've reached your deduction limit.

3. RESP contributions

Loans with Nondeductible Interest:

Contribute to a Registered Education Savings Plan (RESP) up to the amount eligible for the Canadian Education Savings Grant (CESG), as well as to the Québec Education Savings Incentive, especially if your child is between 10 and 17 years old. If you still have funds to invest beyond the amount eligible for the grant, contributing to an RRSP or a TFSA is the best strategy if the expected performance is higher than the interest rate.

4. Unregistered Investments

Loans with Nondeductible Interest:
Priority 1:Maximize to pay off debt.
Take advantage of additional payment on the principal or higher payment options in your contract.
Credits for student loans:
Priorité 2:Maximize to pay off debt.
Loans with Deductible Interest:
Priorité 3:Use all fixed income interest to pay off your debt (see the capsule "Leveraged Loans" and the section on investor profiles).

Save for Retirement or Clear Your Debts?

  • Loans with Nondeductible Interest
    Use any available savings (unregistered) to pay back your loan.

  • Registered Savings Plans
    Any RRSP loan that's totally reimbursed within the year is fine, but any longer and you'll have to consider the difference between the expected rate of return and the interest on the loan. A popular strategy is to contribute to your RRSP, then use your tax refund to pay down your loan. While it is a decent compromise, this strategy is not necessarily ideal. You should decide whether to pay down your loans or contribute to your TFSA or RRSP based on interest rates and expected returns. You will also need to decide whether to contribute to a TFSA or an RRSP (see the information capsule on the TFSA).

    Withdrawing from your RRSP through the HBP cuts into your investment growth, but lets you quickly improve your quality of life. The plan could also let you bypass Canada Mortgage and Housing Corporation (CMHC) fees if you don't have the necessary 20% down payment.

    For more information, see the Flash Retirement information capsule entitled "Leveraged Loans: a Bold Strategy" on deductible interest and the inherent risks of this approach.

Take Out a New Loan?

Before taking out a loan, you'll have to think about repayment and interest rate terms. But first, be sure to draw up a thorough budget to determine how much debt you can really afford.

A number of ratios are used to calculate debt-carrying capacity, but be careful. Think of the maximums as critical limits to stay below. The best benchmark is the impact on your budget. This approach will help you avoid impulse spending and determine how much debt you can actually carry.

  • Repayment Term
    Financial planners agree that long term debts (e.g., mortgages) should be cleared while the borrower is still earning a salary.

    If you buy a home at 40 and plan to retire at 55, don't take a term of more than 15 years. Some people try to pay off their mortgages as fast as possible, whatever it takes. This is a laudable approach, but don't put yourself under too much financial strain or severely restrict your lifestyle for no reason.

    Although interest is nondeductible, remember that capital gains on your primary residence won't be taxed when you sell. Since a home usually goes up in value, the repayment term doesn't really cause a problem because the net value (your home's value minus your mortgage balance) generally rises. Your installments will be relatively linear (a fixed amount) for a number of years, while your employment income will tend to keep up with inflation.

    When you purchase your first home, avoid taking the maximum term. If you run into financial difficulties down the road, you'll appreciate the chance to extend the term when it's time to renew (e.g., from 20 to 25 years).

  • Weekly, Bimonthly, or Monthly?
    When you repay your debts, making payments weekly (or bimonthly) rather than monthly has a miraculous effect. It may seem too good to be true, but it's really just because your total annual payment is higher. If you pay back $12,000 per year at $1,000 per month or $231 per week, your mortgage will be paid off at about the same time. However, the most compelling reason to choose this method is to time your payments to coincide with your payday.

  • Car Loans—Be Practical!
    The term on your car loan should not exceed the normal life of the vehicle (which depreciates fast). A 4 year term is reasonable for a new car. Leasing a vehicle with a buyout option is similar to taking out a loan. The main difference is that your monthly installments are lower than they would be on a loan and you'll have to pay a lump sum at the end of the term if you wish to purchase the vehicle.

  • Credit Cards and Home Furnishing Loans
    Try not to stretch your payments out over more than two years. You'd be better off postponing the purchase or choosing a less expensive item if you'll have a hard time paying it off. It may be a good idea to take out a loan if you can't pay off your credit card at the end of each month, since you'll avoid the sky-high interest on your outstanding balance.

    Special promotional low interest rates can affect your repayment term. For example, it can make sense to take advantage of a no interest "Don't pay for a year" offer, but make sure the amount you'll have to pay in a year isn't higher than what you'd be able to negotiate up front. Never make this kind of purchase if it is beyond your immediate budget or you have other plans for the money.

Interest Rate Terms

Your choice of term will depend on whether you can absorb increases in interest rates. Short terms (lines of credit, 30 days, 6 months) usually carry lower rates than 5 year terms. While it's financially wise to choose a short term (and low rate), you run the risk that interest rates will rise. A 3 to 5 year term on a mortgage can provide peace of mind, especially if you're on a tight budget, like many new homeowners. You can now find even longer terms (for example, 10 or 20 years).

It's risky to select a term solely based on interest rate predictions, since even financial experts often misjudge the markets. Find out how a rise in rates would affect your budget. If the going rate is 4%, calculate whether you'd be able to afford it if the rate were to jump to 6%.

Financial institutions can help you decide. They offer products for a whole range of borrower needs. For those who are self-employed, for instance, there are ways to gradually make interest expenses deductible. Find out about "cash damming", defined in the lexicon.

If you have to take out a loan to pay back other debts, it's important to think it through with a financial planner. By continually pushing back debts, you'll end up pushing back your retirement! Debt consolidation is a good way to take stock and develop a repayment plan to get your finances back on track.

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