The Tax Free Savings Account (TFSA) is big news in the personal finance world. These new tax free accounts have brought about lots of discussions not only about the TFSA basics but also some new and interesting debates. Not too long ago, I discussed the new debate between TFSA or RRSP and came to a conclusion that both have merits. Just these past couple of weeks, I have run into three situations where people are debating between TFSAs and paying down debt. Although I’m a big fan of the TFSA, I came to the conclusion that it may make more sense to pay off debts than keep money in the TFSA.
Credit card debt vs TFSA in savings
Joanne is in her early 30’s working for a software company. Although she has a $6500 credit card balance because of a vacation she took this year, she makes enough income to manage the payments and plans to have the balance paid off before the end of the year. Joanne also has $5000 in her TFSA making less than 1%. The math is really clear that every day she is paying 18% on her credit cards and making less than 1% in her TFSA, she is making the bank a lot of money. When I suggested that she should cash out the TFSA and put it directly against the credit card balance, she was worried that she would not have any emergency money left. As much as I can appreciate the importance of having an emergency fund, the math suggests that she will have the credit card paid off within 2 months and then she can aggressively build up her TFSA again.
Mortgage vs TFSA savings
Amanda and Gary are in their early 40’s with 2 children and quite involved in their financial affairs. They currently have a mortgage of $200,000 at a 4% interest rate and plan to have the mortgage paid off in 15 years. Gary contributes about 14% of his pay to RRSPs through payroll deduction and employer contributions. They each have $11,000 in their TFSAs and hope to put another $5000 lump sum each into the TFSA. Just like Joanne (above), they like the idea of having the TFSA as an emergency fund and as a result, the interest they are making is about 1%.
Although the math is not as extreme when comparing the TFSA return to credit card debt, the math still works in favour of paying down the mortgage. If you have an account earning you 1% while having debt that costs you 4%, you are going backwards. Putting the TFSA money towards the debt is the equivalent of earning 4% on the money instead of 1%.
Amanda and Gary have a $25,000 unsecured line of credit in Amanda’s name from early in their marriage. They have used this line of credit only once and had is paid off within a few months. Given their discipline and aversion to debt, they are prime candidates to use the Line of credit as their emergency fund. For those that lack discipline, a line of credit can be problematic.
What should you do with extra cashflow?
Melinda and Santos are about 5 years to retirement. Although they are mortgage free, they do have a $50,000 line of credit they want to have paid off by the time they retire. They are paying $1000 per month directly to the line of credit. They are also putting $500 per month to the TFSA into low interest savings to also supplement their retirement spending. Would that $500 per month be used more effectively if it went directly to the line of credit instead of the TFSA?
By putting the $500 per month towards the line of credit, they are earning the equivalent of 5% due to the interest savings. They are not earning anywhere near that in their TFSA. By putting the entire $1500 per month directly to the debt, they would have it paid off in 3 years and then could aggressively build up the TFSA then. I've refered to this in the past as the principles of cashflow.
Some final thoughts . . .
I run into so many people that are not investing their TFSAs. If you are going to keep TFSA money in low interest savings, you may be better off using the money towards debt than keeping it in the TFSA.
If you have credit card debt at high interest costs, then no matter what you invest in, you should consider the merits of paying down credit card debt instead of investing in TFSAs.
Although these three examples are based on real life people and real life situations, they merely serve as examples. The best way to tackle any financial debate like the TFSA vs RRSP or the TFSA vs paying down debt, remember that everyone has unique circumstances and individual planning is always recommended.