One of the questions I get a lot is what people should do with extra money, whether its $100 or $1000 or more? Is it better to buy RRSPs or pay down debt? Should I put some in the TFSA or or just keep it in savings? Am I better paying down the mortgage or the line of credit?
Recently, I shared the story about Jackie who was saving money in a TFSA when she really should have been paying down debt (Debt is a good reason not to save). Since the cost of debt is usually higher than the interest from savings, paying down debts can be one of the best investments you make.
In response to that story, Justin wrote to me saying he has an extra $100 per month that he wants to do something. He is wondering if it is better to buy RRSPs, a TFSA or pay down some debts.
The answer is “It depends”. What does it depend on? Lots of things like Justin’s income, tax rates, financial stability, objectives for the money, debt levels, current expenses, marriage status, job stability, age, and so on and so on. Making financial decisions is not always easy but sometimes we can try to find some common approaches to simplify the decision making process. Although every one's situation is personal, there are some general rules of thumb to share with you. It’s not perfect but we can apply some math to try to figuring out the best course of action. I’ve written about the principles of cashflow before but this is an opportune time to update it because TFSAs did not exist then.
Principles of cashflow
So Justin wants to know what he should do with an extra $100. It does not matter whether you have an extra $100, $1 or $100,000, the principles of cashflow simply suggest that given extra money, there are better financially productive ways to use that dollar. Here’s some general thoughts about the principles of cashflow (keep in mind that everyone has unique circumstances):
- Pay off high interest credit card debt first. The credit card math will work against you every time especially if you are paying 18% or more in interest. Paying down this debt is always a great place to start if you have extra money. It’s also important that you have the discipline to NOT accumulate the debt again once you pay it down.
- Look at the RRSPs first to see if they make sense. One of the benefits of making a RRSP contribution is that you get a tax deduction. The best way to see if the tax deduction benefits you, is to follow my ONE FORMULA approach to RRSPs – If your marginal tax rate (MTR) at the time of contribution is greater than your marginal tax rate at the time of withdrawal, then the RRSP will always give you a benefit.
- Paying off non-deductible can be a great investment. Just check out the math in this article – paying down debts. Basically paying down a 6% debt can be the the equivalent of earning 8.8% on a GIC. Paying down non-deductible debt can be a great investment. The higher the cost of interest, the better the investment.
- Buy TFSAs. One of the problems with TFSAs is the title has mislead a lot of people into putting their money into low earning savings accounts when there are lots of ways to invest TFSAs. TFSAs have a lot of universal appeal so they could easily move up the list depending on your personal circumstances.
What was Justin’s decision?
In the end, Justin decided to take the $100 per month and put it against the debt. He was already contributing to RRSPs through work so felt that getting rid of debt was smarter than buying the TFSA.
Similar to Jackie, if you have debt, then paying down the debt probably gives a better return than saving money. Whether it’s a lump sum like Jackie or monthly cashflow like Justin, using some math can help determine the obvious choice even though the answer is “it depends”.