With markets going sour and peoples attitudes towards investing moving towards the emotions of capitulation, despair and pessimism, one of the best investments you can make is to pay off your debts.
Debts can be more expensive than your think
Most Canadians hold non-deductible debt. Simply put, this means that the interest you pay is non-deductible. Falling in this category are personal mortgages, personal lines of credit, credit cards, car loans, etc.
The problem with non-deductible debt is it takes more than a dollar to pay a dollar of interest. Think about it, we all pay tax on the money we make and when we make a dollar, we may only get to keep 70 cents.
So, if the interest on your mortgage is 7%, that is the equivalent of paying 10.8% on an after-tax basis assuming a 35% marginal tax rate. Therefore, paying off that mortgage is the equivalent of making a guaranteed 10.8% investment. If GICs were paying 10.8% how many of you would jump at that investment, especially given our current state of the markets.
Below, you will find some data showing you your after tax benefit of paying off 7% debt. Look for your current marginal tax rate across the top. In that column, you will find the after tax cost of your debt.
After-Tax Cost of Non-Deductible Debt
|Marginal Tax Rate|
As you can see, the higher your marginal tax rate, the higher the after-tax cost of interest. What can you do to minimize this cost?
Converting to deductible debt
There is such a thing as good debt and bad debt. One of the best kinds of debt, if used properly is deductible debt. According to the CCRA, the interest on your loans are deductible if the debt is used for (1) the purpose of business and (2) for investing.
Here is an example of converting non-deductible debt to deductible debt. Let’s assume you have $10,000 line of credit. Let’s further assume you have $10,000 invested in Canada Savings bonds, GICs, or mutual funds outside of the RRSP. Here’s what you can do to convert non-deductible debt to deductible debt. Firstly, take the investment and cash them in. Use this money to pay off the line of credit. Then, re-borrow off the line of credit to invest back into the same investments you once owned. Since you used the borrowed money to invest, you can now deduct the interest.
Please keep in mind this example is over simplified. It ignores the effect of taxes and fees that can be triggered when selling the investment in the first place.
Deductible debt is good debt
|Marginal Tax Rate|
Unlike the other chart, deductible debt gets cheaper if you have a higher marginal tax rate. If used wisely, deductible debt can actually be your friend.
According to the ‘Millionaire Mind’ by Thomas Stanley, one of the characteristics of wealthy people is they have no debts. My parents came from the old school where it was always a priority to pay off debts. Given the chart in this article it is easy to see why this was a good investment.
Furthermore, debt can be used to your advantage but only if the interest is deductible. The rules can be more complicated and you should consult an accountant or a financial advisor when trying to create deductible debt. You must understand the risks of using leverage or deductible debt.
Finally, pay off debts in order of highest interest to lowest interest. Also pay off non-deductible debt before deductible debt.