Should You Pay Off Debt or Invest?

Pondering over the question, “Should You Pay Off Debt or Invest?” is not unusual, especially when you experience an unexpected financial windfall. This article encapsulates expert opinions, real-life experiences, and mathematical realities to help you make an informed decision.

The Dilemma: Pay Off Debt or Invest

To begin with, let’s understand this common financial dilemma. Imagine you receive a sudden windfall of $10,000. Now, you have two options: either pay off your existing debt or invest it for future returns. Which path should you choose?

Expert Opinions

Sean Cooper’s Perspective

Sean Cooper, a renowned personal finance blogger, shares his perspective on the matter. According to Sean, the sense of relief that comes with paying down your debt can often outweigh the potential returns from an investment.

 

“If you have credit card debt, of course that would definitely make sense to pay that down rather than invest. Because, with credit card debt being 19% or higher, with some retail credit cards having almost 29%, 30% interest rates, you should definitely pay that down sooner.”

 

A Licensed Insolvency Trustees’ Outlook

Our trustees suggest that the decision to invest or pay off debt depends on the tax rate and risk. If the interest on your mortgage is 3%, and your investment would return 4%, the income tax could reduce your return to 3%. Therefore, both options become financially equivalent. However, risk factors need to be considered as well.

 

“The lower the amount of money we’re talking about, the more inclined I am to say that it’s not worth any kind of risk, your safer rate of return is to pay down the debt.”

 

When Not Paying Off Debt Makes Sense

There are certain scenarios where not paying off debt could be beneficial. For instance, if you have a low-interest car loan and no other unsecured debt or mortgage, it may be more logical to place the money in a TFSA for emergencies.

 

“It’s a horrible trap that people can fall into. You think you did the best thing possible by paying off all your debt, but if you don’t have debt, if you’re not using credit, then they don’t score you as high as somebody who regularly uses credit and makes all the required payments. So, if there’s no history there, if they can’t look to see you owe this money and you make your payments every month, you don’t rate as highly as somebody that does. It doesn’t make a lot of sense.”

 

When Paying Off Debts Is Preferable

In case of high-interest credit card debt, investing might be a less beneficial choice. For instance, if you’re carrying debt on a high-interest credit card with 15% -22% interest or on a store credit card with 29-30%, you will have a better rate of return putting the $10,000 towards your debt than you would investing it at a 4% rate of return.

Even with the option of putting $10,000 into an RRSP and receiving $2,500 in a tax refund, the math doesn’t work for many reasons:

 

  • The tax refund comes several months later and you are paying interest in the meantime;
  • The refund likely doesn’t cover the full interest costs on credit card debt for a year;
  • You only get a tax break once, the credit card debt remains until it’s paid in full.

 

The Bottom Line: Math and Risk

Ultimately, the decision to pay off debt or invest boils down to two factors: math and risk. Paying off debt, particularly high-interest debt, is often a safer and more financially sound decision. However, if you have low-interest debt and a high risk tolerance, investing could be a viable option.

Remember, the goal is not just to grow your wealth, but also to reduce stress and risks. Therefore, consider your personal situation, risk tolerance, and financial goals before making a decision.

In conclusion, the question, “Should You Pay Off Debt or Invest?” is not a one-size-fits-all kind of situation. It depends on the type of debt, the interest rate, your risk tolerance, and many other factors. However, as a general rule, if the interest rate on your debt is high, paying it off should be your priority. If your debt is manageable and the interest rate is low, investing might be a more beneficial choice. Always consult with a financial advisor or professional to make the best decision for your unique situation.

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