Debt might be a good reason not to save
A recent study by the Royal Bank is showing that Canadians are having tough time-saving money. Over the past 2 years
- 46% of people have stopped or reduced savings
- only 12% have increased savings
- 38% of people are not saving money
- only 33% are saving regularly.
- 55% of Canadians find it is hard to be disciplined to a savings habit.
Although these statistics might be alarming, should we really be surprised? We live in a society that values consumption. For the past 20 years, the solution to the economic slowdown was to encourage spending. Spending is the opposite of savings. They are like two heavyweight champs battling it out for the belt and unfortunately, spending is winning the battle.
If you think about it, spending is more natural. It’s more fun. Its kind of like a drug in that spending makes us feel rich. Ironically, the only way to get rich is to save more money and not spend it!
Should people really be saving more money?
The obvious answer to this question appears to be yes but having lots of debt might be a reason why you should not be saving money. It’s likely that there is greater benefit in paying down debt before you start saving.
Recently I met with a single mother named Jackie who is raising 2 children on her own. She has accumulated about $20,000 of debt on her personal line of credit and is really stressed about it.
When we look at Jackie’s assets, she has $50,000 in RRSPs and $10,000 in a TFSA. She considers her TFSA her emergency money.
If you think about it, It makes no sense having money in savings earning 1% or less when you have debt costing you 5% or more. Every day you have this scenario, you are going backward financially. Paying down debts might be the best form of savings and investing.
Paying down debt can be one of the best investments you make
My suggestion to Jackie was to take the TFSA and put it right against the line of credit. My justification for this was simple. Every day she has these savings and TFSA making about 1.5% she is losing money. She is losing money because her line of credit is costing her 5%. Holding both the savings and the debt at the same time guarantees a profit for the bank and a losing strategy for her money.
If you want to get technical about it, the debt is actually costing her more than 5% on a pre-tax basis. In order to pay down a dollar of interest, on the line of credit, Jackie must make more than a dollar at work because she has to pay tax. In other words, she earns $1.47 to net one dollar after tax.
By using the $10,000 towards debt, she will save $41.67 per month in interest. Keeping the TFSA makes her much $12.50 per month which is much less than the $58 monthly cost.
But what happens in case of an emergency?
Jackie understood the math, but still expressed the concern that she would not have any savings or emergency money.
It’s important to remember that Jackie has less debt and can use her line of credit as the emergency fund. This strategy only works if you have the discipline to not run up the line of credit again.
The bottom line
Jackie’s situation is a perfect example where saving money does not make sense because there is a bigger bang for her buck in paying down debts. I think we forgot somewhere along the line that paying off debts can be one of the easiest and smartest investments we can make. Instead, debt has become big business and financial institutions are quick to encourage more debt as opposed to getting out of debt.
A smartly crafted article and idea. Not only will Jackie fare better overall, but as she pays down her debt, it’ll cost her less each month in interest. As she pays down the debt she’ll be saving more and more and can put that extra money towards the debt as well. She be paid off and debt free in no time. That’s when the real savings can begin. Thank you for some sound financial advice.
Great post Jim.
However, although I dislike debt, it can be a tough decision sometimes. For example, we have a few thousand in our TFSAs but we also now have a few thousand on our LOC because of a new roof installation this spring. Should we cash out the TFSAs to pay off the debt? I’m not convinced. Why? Because our TFSAs are yielding over 4% and the LOC interest is 4%. As long as the investment is making more than the debt interest, we’ll be aggressively paying down our LOC but we won’t touch our TFSAs to do it.