TLDR
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When it comes to investing or paying down debt, both have their benefits.
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Investing can set you up for your future.
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Paying down debt can save you money, and maintain your creditworthiness.
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Consider a balance of paying down debt and investing based on how much high-interest debt you have, and consider consolidating your debts into a lower-interest line of credit.
It’s been said that finances is like tending to a garden. There are many decisions that we make that can contribute to a healthy and thriving garden. Do our flowers need more water? Do they need more sun? When it comes to finances you may have to decide whether to invest or pay down debt.
Sometimes those decisions can trip us up. Where exactly do we put our money to put us in the best possible financial position down the road?
If you find yourself in the enviable position of having some extra money, you may ask yourself, is it better to invest or pay down debt? The easy answer is both! But, while both can be advantageous, there are some nuances around when and how much. Here’s what you need to know about making those decisions for your unique and personal financial circumstances.
Advantages of Investing
Investing your money for the future has many benefits, such as:
Growing your wealth over time
Investing doesn’t just allow you to put money away for when you need it. Investing regularly allows you to harness the power of compounding. Compounding is the process of earning interest on the original investment and then earning interest on the interest that has already been earned. This process can lead to exponential growth over time.
Lowering your taxable income
Depending on your goals, risk tolerance and time horizon, you can choose where you want to hold your investments. Using a Registered Retirement Savings Plan (RRSP) to hold your investments allows you to deduct your contributions from your income, and defer the tax until withdrawal, usually at retirement. You can also choose the types of assets you want to hold, and potentially grow, in those accounts, such as mutual funds or Guaranteed Income Certificates (GICs).
Protecting yourself against inflation
The cost of living goes up as time goes on. The result of inflation is that the money you make this year might not have the same purchasing power down the line. Investing is important so that your savings can keep up with rising costs, particularly over the long term. This is important so that your savings can grow to help keep up and ideally exceed the rising costs of living, particularly over the long term.
Creating an emergency fund
Investments can also be a great way to build an emergency fund for those unexpected expenses. Having money that’s set aside and growing can lessen the impact of a financial emergency, such as illness or being unemployed.
Investing does usually come with some risk, however. The more risk you are willing to take on, the greater the potential returns.
Advantages of paying off debt
Debt comes in many forms. Here is where you might find it:
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Your mortgage
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Credit card balances
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Lines of credit
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Student loans
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Automobile loans
Tackling debt, especially high-interest consumer debt, such as debt from credit cards, can also have benefits:
Improving your financial well-being
Seeing your credit card balance grow faster than you are paying it off can cause a significant amount of anxiety. Having a plan to reduce debt can mean less stress and better mental health. Paying down debt can also mean more cashflow as you owe less over time. This can mean you are in a better financial position to plan and save for the future.
Lowering interest costs
Paying debt faster, especially high-interest debt, can save money on interest. For example, if you are carrying a balance of $8,000 on your credit card, at an interest rate of 20 per cent, you will pay over $5,000 in interest if you make a monthly payment of $200 over five and a half years. Up your payment to $500 per month, and you have reduced your interest to just $1,381.97 and will have the balance paid off in just over one and a half years.
Increasing your credit score
Having a lot of debt can negatively impact your credit score. Financial institutions use your credit score to determine your creditworthiness. By ensuring that you make payments on time, and reduce your debt, you’ll show credit organizations that you are responsible and accountable for the debts you owe, and you will have less trouble obtaining credit in the future when you really need it.
Why you should consider doing both
Paying down debt and investing for the future are both valuable, so you may wish to consider a financial plan that incorporates both investing and paying down debt. Investing can set you up for the future, while paying down debt keeps your cashflow healthy, prevents your debt from spiralling, and maintains your creditworthiness. So how do you strike the right balance?
The rule of 6%
There is a rule of thumb that suggests that if the interest rate on your debt is higher than 6%, paying off debt may be more advantageous. If it is lower than 6%, investing more might be preferable. However, this is a general rule, and you might wish to factor in your risk tolerance. For example, if you are more risk averse, you may feel more comfortable paying down debt instead of investing more.
How to pay off debt: some useful tips
When it comes to paying down debt, there are some useful strategies to consider:
Start with the debt with the highest interest rate
The”avalanche method”focuses on paying the loan with the highest interest rate loans first. When your higher-interest debt is paid off, you work on paying off debt that have the next highest rate, until you are done. This helps to save money in interest as you’ve addressed the most interest-bearing loans first.
Look into lowering your minimum payment
In some situations, you may be able to negotiate with the lender to lower your monthly minimum payment if you are having a hard time keeping up. By ensuring that you make your payments on time, you can keep your credit score up.
Consolidate your debts
Speak to your financial institution about consolidating all of your debts into a lower-interest credit option, such as a personal loan or line of credit. This may make it easier to pay your debt with one lower payment and save on interest.
Pre-authorized contributions and debits can help to pay down your debts and also grow your investments automatically. If you are unsure where you should be directing your money, a financial advisor can help you to define your goals, establish a budget and determine which investments are right for you.
With the right know-how and help, tending your financial garden may reap rewards.
Mutual Funds are sold by Royal Mutual Funds Inc. (RMFI). There may be commissions, trailing commissions, management fees and expenses associated with mutual fund investments. Please read the Fund Facts/prospectus before investing. Mutual fund securities are not insured by the Canada Deposit Insurance Corporation. For funds other than money market funds, unit values change frequently. For money market funds, there can be no assurances that a fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in a fund will be returned to you. Past performance may not be repeated. RMFI is licensed as a financial services firm in the province of Quebec.
Financial planning services and investment advice are provided by Royal Mutual Funds Inc. (RMFI). RMFI, RBC Global Asset Management Inc., Royal Bank of Canada, Royal Trust Corporation of Canada and The Royal Trust Company are separate corporate entities which are affiliated. RMFI is licensed as a financial services firm in the province of Quebec.
Personal lending products are provided by Royal Bank of Canada and are subject to its standard lending criteria. If your credit history is limited, or you are studying at an educational institution outside of Canada, a co-signor may be required.
