THE AGE-OLD QUESTION IN PERSONAL FINANCE
Imagine that you’ve won the lottery. Not enough to fully fund an immediate and lavish retirement, but enough to make a difference in your life. How would you spend your windfall?
Most of us who dream of winning say we’d pay down our debt, and maybe donate to charity or splurge on a big-ticket item like a much-needed vacation. Many people who actually win end up blowing it all; they fail to invest in the future.
So, what would you do? Would you pay off your debt or would you invest?It’s a worthwhile question to ask, even if your odds of winning the lottery are slim, because there’s a fair chance you’ll come across a chunk of money in your lifetime. It might be in the form of a tax refund or an inheritance. Or maybe you get a promotion or bonus at work. Or your kids will finally get a handle on the whole “adulting” thing and move out of your house, significantly reducing your living expenses.
Or maybe the only thing that changes is your mindset, and you decide to put your money to work in a different way.
What’s the smartest thing you can do with your money?
Option 1: Pay down debt
First, we need to recognize that not all debt is created equal. The debt you carry on a high interest credit card is a lot different than the debt you carry on your mortgage, and how you deal with your debt will largely depend on how much and what type of debt you have.
If you choose to focus on paying down your debt, there are several different approaches you can take. Here are three of the most common:
The cash flow method. With this method, you focus on paying down the loans that have the biggest minimum payments, thus freeing up a larger amount of cash flow. This makes the most sense if you’re living paycheque to paycheque (like your fledgling ‘adult’ child) or if you need to free up cash for a future expense.
The snowball. Coined by financial guru David Ramsay, this method focuses on paying off the smallest balance first regardless of interest rate. It doesn’t make mathematical sense, but it’s emotionally effective because feeling like your making good progress helps build momentum. If you add things you’ve already done to your ‘To Do’ list just so can reap the motivational high of crossing them off, then you know exactly what I mean, and this method may be the right one for you.
The avalanche. With this method, a mountain of powdery snow cascades over you and whisks your financial troubles away …
Just kidding. In the avalanche method (a.k.a. debt stacking), you focus on paying down the loan with the highest interest rate first, while still making the minimum payment on all other loans. This method saves you the most money in the long run because you end up paying less in interest. But depending on how big your high interest debts are, it may take a while before you feel like your making progress.
Option 2: Invest your money
First things first, you want to make sure you have an emergency fund in place so that you don’t have to go into debt if something unexpected comes up, like a major home repair (or your kid moving back home).
Most advisors recommend an emergency fund equal to six months income. This can seem like a lot if you haven’t started yet, but there are plenty of ways to save money faster than a traditional low-earning savings account or shoebox under the bed. For example, if you put your money in a tax-free savings account (TFSA), you won’t pay any tax on the interest earned and still be able to access your money on short notice if needed.
Like paying off debt, there are many ways to invest, each with its own advantage. Contributing to a Registered Retirement Savings Plan (RRSP) can reduce the amount of tax you have to pay now. And, since you don’t pay tax on your investment earnings while they’re in the RRSP, your investment will grow at an even quicker rate. Visit our TFSA vs. RRSP Planning Tool here.
Or you can consider investing in a mutual fund*, where your money is combined with other people’s money to invest in a group of stocks or bonds. Mutual funds are an easy way to diversify, and with so many to choose from, you’ll be able to invest in a way that suits your risk comfort level and personal goals.
Invest or pay off debt: how do you possibly decide?
Paying down your debt saves you in interest, and if you have high interest consumer debt like a credit card, you’ll likely want to pay that off first. It’s costing you a lot of money that could be better spent on other things, like investing in your future.
You’ll also want to pay down your debt if your payments are consuming an uncomfortable amount of your income. This will free up your cash flow, meaning you’ll have more money to enjoy now or – again – invest in your future.
On the other hand, if you have a strong credit rating and your paying low interest rates on your current debt, then it may make better financial sense to invest your extra money now. In this case, the interest you’ll earn on your investments over the long-term will likely be greater than what you’ll end up paying on your debt, so you’ll ultimately come out ahead.
Your life is unique, and so are your finances. This means that there is no one-size-fits-all solution. Whether you want to reduce your debt or grow your investment portfolio -- or a combination of the two – you need a customized plan that works for you.
And this is where it makes sense to work with a professional Wealth Expert. Their goal is to support your overall financial health and well-being – and that means looking at what you owe, as well as what you want to earn. They’ll help you design a workable financial strategy that addresses the choices you’ve made in the past, supports your lifestyle today and builds toward the goals you’ve set for tomorrow.
And once you have a solid financial plan in place, you won’t need to win the lottery to achieve your dreams.
The information contained in this article was obtained from sources believed to be reliable; however, we cannot guarantee that it is accurate or complete. This article is provided as a general source of information and should not be considered personal advice. Mutual funds, other securities and securities related financial planning services are offered through Credential Securities, a division of Credential Qtrade Securities Inc. Credential Securities is a registered mark owned by Aviso Wealth Inc. Mutual funds and related financial planning services are offered through Credential Asset Management Inc.