Sunday, February 3, 2008

Debt vs Savings

Is it better to solely save or solely pay off debts or is there a better combination? As with most financial questions the answer is it depends. You need to consider what is the after tax return on investment compared to the cost of the debt. Another thing to consider is the risk involved in the savings; is it a GIC or is it a medium or high risk mutual fund?

After tax ROI (Return On Investment)

It is important to understand that the amount of money generated by an investment will probably be taxable. For example I put $2000.00 in a 3.65% in ING's ISA I will end up with after one year with $2074.23 or a taxable gain of $74.23 at my tax bracket of about 40% I will owe in taxes $29.69 this can be calculated to be an after tax ROI of approx. 2.21%. It is pretty obvious that if your choice is between saving the $2000.00 or paying off a $2000.00 credit card debt at 18%+ then pay off the credit card. Especially since you are not taxed on the interest saved.

What if the debt is not a credit card but a home equity line of credit at 5.47% and it is an RRSP (Registered Retirement Savings Plan) in Canada (or its equivalent in another country)? It will again depend on what is the return on the RRSP and what tax bracket you are in.

I found a RRSP vs. Mortgage Calculator to figure out for my case what is better. I entered the following into the calculator:

Mortgage rate : 5.47%
Principal Outstanding: $148134.44
Monthly Payment: $913.22
RRSP ROI: 4.5%
Lump sum: $0
Extra Monthly: $1950.00
Marginal Tax Rate: 40%

The calculator result:

Based on the mortgage information provided, we have calculated that you have 24.00 years remaining in your mortgage amortization period.

If you increased your monthly mortgage payment by $1,950.00, it would result in your mortgage decreasing by $128,703.93 and your mortgage amortization period will be reduced to 4.83 years.

If you increased your monthly RRSP contribution by $1,950.00, it would accumulate over 4.83 years to $125,800.48. The tax savings over the next 4.83 years should be approximately $42,900.00.

Of course, if you used your tax savings to pay down your mortgage, it would result in your mortgage decreasing by a total of $111,636.81 and your mortgage amortization period will be reduced to 9.25 years.

Based on the information provided, you would be better off paying down your mortgage.

Risk Assesement

I am sure that there will be those of you out that will say that 4.5% return is too conservative and that I should be able to get a better return than 5.47% of the mortgage. This maybe true but this is speculative and I need to make sure that I compare apples with apples and not oranges; the debt repayment impact is guaranteed but investing in anything other than 0 risk RRSP is not.

Noticed that if with my low interest home equity line of credit it is better to pay off the mortgage first than this will be even more true with my higher interest debt.

I also tend to be getting less risk tolerant as I get closer to my target age for financial independence which I had set earlier to be age 55. This for me is just over 15 years from now.

I hope this article was useful to you and hope to hear any comments you may have.

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