Principles of cashflow
One of the most common questions I get as a financial advisor is whether it is better to pay down the mortgage or whether it is better to invest in RRSPs.
Unfortunately the answer can be quite complex because it depends on what tax bracket you are in, the rate of return on investment and the interest rate on the mortgage.
The principle, however, deals with effective use of cashflow. If you have an extra dollar, what is the best use of that dollar? I offer you some general advice. Keep in mind that everyone has unique circumstances and you should consult a financial advisor for a detailed review of your personal situation.
- Pay off high interest debt like credit cards. Remember that for every dollar you pay in interest, you must earn at least $1.35 because we must pay tax on every dollar we earn. High interest debt is really costly.
- Invest in RRSPs. Generally speaking, the tax deduction you get from RRSPs makes this one of the best investments. Albertans in the middle income bracket will save about 39 cents in taxes for every dollar they invest in RRSPs. That equates to an immediate 39% return.
- Pay off non-deductible debt. I have talked about this in previous articles but even mortgages at low interest rates can be more costly than you think. Consider that a 6% mortgage today is the equivalent of about 9.8% after tax because we must pay interest with after-tax dollars.
- Invest in non-RRSP investments. Paying down debts might be better than investing in non-RRSP dollars depending on what you think you can earn on investing. With interest rates creeping higher, debt becomes more expensive. In point 3, if you cannot earn 9.8%, you are better off paying down a 6% mortgage.
- Deductible Debt can be your friend. Often we perceive that debt is bad and generally that is true because we have to pay debt with after tax dollars. However, deductible debt is a more efficient use of debt. If we borrow for the purpose of investing or business, CCRA (formerly Revenue Canada) allows us to deduct that interest as an expense. For example, a Line of Credit for investing at 8%, really only costs us about 4.9%. Would you borrow money at 4.9% if you could earn 8%?
- Investing in RRSPs first allows you to use the tax savings to pay down debts. If you have one dollar after tax, and you pay down debt, you have used one dollar. However, if you invest that dollar into RRSPs, you will have an extra 39 cents to pay down debt. By investing in RRSPs first, you have created $1.39, part of which goes to investing and part to debt reduction.
- Universal Life can be a great investment. Keep in mind that I think RRSPs and debt reduction of non-deductible debts are higher on the priority list but Universal life can be an excellent form of investing on a tax sheltered basis. You must pay for the cost of insurance so one of the key aspects is the cost of insurance should be lower than the tax paid from investing.
(The examples here assume that you are in the middle income bracket). In the end, it is important to budget and spend less than you earn. If you do that properly, you should consider the most effective use of your dollars.