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Personal finance

Paying off debt or investing: How do you choose?

April 5, 2021

Paying off debt or investing? The choice isn’t always easy. But before we get into the heart of the matter, it’s important to distinguish between good debt and bad debt.

Let’s let Philippe Guérin, Financial Planner at Desjardins Wealth Management, explain what this is all about:

“Don’t lump all debts together! Some of them are considered good because they relate to assets that can increase in value, such as real estate. So it’s perfectly normal, for example, to take out a mortgage loan to acquire a property, while making sure to respect your ability to repay. On the other hand, financing assets that don’t appreciate, such as cars or technological devices, falls into the category of bad debts, since they’ll eventually lose their value.”

Are you hesitating between reducing your liabilities or increasing your assets? We’ll help you decide using the following approach.

Step 1 - Review your financial situation

Over the years, your income has probably increased, which may imply that your lifestyle has followed this trend. Your fixed expenses, such as monthly mortgage or vehicle lease payments, as well as lines of credit and other forms of consumer lending, may have gone up as well, fuelling the debt spiral.

Here are some questions you need to answer:

  • Are you still in line with your financial goals or do you need to adjust them, especially in terms of saving and paying down debt?
  • Do you have a tight budget? Are you able to balance your expenses, debts and savings?
  • Is your debt-to-income ratio (total monthly payments ÷ total monthly income) less than 36%?*
  • What is your net worth, that is, the sum of your assets (all the monetary assets that you own and that are part of your wealth) less the sum of your liabilities (debts, obligations and expenses)?

If your debts are piling up, it’s vitally important to take stock of your financial situation. Since you have probably acquired assets and accumulated financial commitments over the years, preparing or updating your balance sheet is the best way to get an accurate picture. You’ll then get an overview of your financial situation, from which you can develop an action plan.

Step 2 - Identify your priorities

No matter where you are in life, you need to know how much of your income must go toward paying down debt and increasing your savings. This apportionment must also be in line with your short- and medium-term goals and how you want to achieve them.

Are you planning to do major renovations or purchase a cottage or trailer? Will you be able to go ahead with those plans while keeping some flexibility in your retirement planning? By taking your financial capacity and your budget into account and setting a timeline for each of your projects, you can set clearcut priorities and achieve them at your own pace.

Step 3 - Draw up your game plan

As you can imagine, when it comes to choosing between paying down debt and increasing your investments, there’s no magic formula. Of course, it’s generally preferable to pay off your debts quickly, starting with high-interest debts such as credit cards.

One thing you can be sure of is that your financial advisor or planner can help you draw up a plan tailored to your situation and needs.

Here are some tips to help you with your planning:

  1. If you have multiple financial commitments, consider whether they can be consolidated or their interest rates reduced.
    Use the equity of your property to take advantage of a home equity line of credit and its attractive interest rate.
  2. Compare borrowing rates and investment returns in order to make informed decisions.
    When deciding whether to repay a loan or to invest, it’s important to consider the risk of not obtaining the expected return, as well as the tax on the return obtained. Repaying the loan will often be the wisest choice.
  3. Make sure you have access to cash by having an emergency fund that gives you flexibility in case something unexpected happens.
    By investing in a Tax-Free Savings Account (TFSA), your savings will grow and, depending on the investments you select, you’ll have quick access to funds when you need them.
  4. If you can, maximize your contributions in investment vehicles that enable you to grow your savings in a tax-efficient manner.
    With a TFSA, you can increase your savings tax-free, just like an RRSP. The latter also reduces your taxable income, which could make you eligible for income-based government benefits or programs.
  5. Once your debts are paid off, use the money that went toward debt repayment to increase your savings.
    When you’re done paying for your car, deposit the monthly amount of that expense into an investment vehicle of your choice and see your savings build up handsomely.

Increase your wealth by paying off debt and investing!

Discipline and planning are two ingredients that can help you implement an effective action plan for managing your debts and savings. Use your action plan to reduce your financial stress and look to the future with peace of mind. You’ll also be able to focus on your investments and plan your dream retirement.

*A 30% debt-to-income ratio is considered excellent, a 30% to 36% debt-to-income ratio is considered good, while a debt-to-income ratio of more than 40% could jeopardize the approval of a car loan, student loan or mortgage, not to mention the difficulty you may have in repaying such loans. Unlike your credit rating, which provides a picture of your credit history, the debt-to-income ratio takes your current income into account.