There’s never been a better time to not invest.
Stocks are erratic these days, bonds have been sinking and cash pays close to nothing. Struggling with debt? Then that’s where your money should be going in the near term.
Here’s another reason to take a short break from investing, of up to a year, to pay down your debts. Interest rates in the bond market have started to rise, and fixed-rate mortgages have already started to follow along. Most economists expect the interest rates influencing lines of credit and loans to rise in the latter half of next year, which means you’ve got roughly a one-year window to pay down your non-mortgage debts before the cost of carrying them starts to edge higher.
The big question in deciding whether to invest or pay down debt is, Which gives you the best return? Too many people disparage the debt repayment option these days on the basis that interest rates are low enough to be easily surpassed by investment returns.
In theory, sure. The S&P/TSX composite index averaged 8.4 per cent annually over the decade to June 30 (including dividends), while the DEX Universe Bond Index averaged 5.3 per cent. By comparison, home equity lines of credit charge in the area of 3 to 4 per cent. Even a basic car loan, one of the pricier ways to borrow money today, can be had for 5 to 7 per cent.
Now, for a reality check on those investing numbers. For one thing, fees could reduce your returns by 0.5 to 2.5 per cent, depending on what type of investments you use and whether you have an adviser or make your own investing decisions. Also, financial markets are as ornery today as they’ve been in years.
Bonds, long the investor’s trusty friend, have fallen sharply in the past two months. Some of the most popular bond funds were down 1.5 to 2 per cent for the first half of 2013, and more losses could be coming. Stocks have been especially inconsistent this year. The S&P/TSX composite index was down a bit less than 1 per cent for the first half of the year, while the S&P 500 ended the first half with gains around 14 per cent. Some market watchers think U.S. stocks have some downside risk at this point.
Long term, market summaries like these are unimportant. But if you’re comparing investing opportunities to the benefits of paying down debt, you’ll want to look at immediate results. In that light, debt paydown offers guaranteed benefits and investing offers uncertainty.
Another issue in reviewing the benefits of paying down debt and investing is taxes. Interest on money borrowed for investment purposes is tax deductible, but never mind that. The kind of debt we’re looking at here is the conventional, non-deductible kind that had its origins in a new car, a home renovation, a trip or other types of consumption.
Taxes on your investment gains are another consideration. Ernst & Young’s 2013 online personal tax calculator shows that someone earning $75,000 would be taxed as follows:
- Regular income (including interest paid by bonds and term deposits): A marginal tax rate as low as 29.7 per cent in British Columbia and as high as 39 per cent in Manitoba.
- Eligible dividend income (the kind paid by big corporations): Thanks to the dividend tax credit, marginal tax rates here would range from a low of 9.6 per cent in several provinces to a high of 22.6 per cent in Manitoba.
- Capital gains: A low of 14.9 per cent in B.C. and highs in the 19 per cent range in several provinces; note that only 50 per cent of capital gains are taxable.
Taxes make it harder for investing to produce better results than debt paydown, but there are remedies. You could set up a tax-efficient portfolio using a total return approach, which is based on dividends plus capital gains derived from share price appreciation. That way, you benefit from the lighter tax hit on dividends and capital gains.
You could also invest in a tax-free savings account, where tax is a non-issue, or a registered retirement savings plan, where you will presumably pay taxes at a lower rate than today when making withdrawals in your retirement years.
Mainly, the advantage of paying down debt instead of investing hinges on the interest rate charged on the money you owe. Credit cards are in the range of 20 per cent these days, which means paying them off instead of investing is a no-brainer.
Loans and unsecured credit lines have rates in the mid to high single digits, which argues in favour of debt repayment as well. With home-equity lines of credit, where the rate can be 3 to 4 per cent, the investing versus debt repayment debate gets a little more difficult to settle. If your line of credit balance never seems to drop much, forgo investing and pay what you owe. If you’ve made a special one-time purchase on your credit line and have a realistic plan to pay it off in less than 12 months, then there’s no reason not to keep investing.
The toughest call is whether to invest or pay down your mortgage. Homeowners who bought in the past year or two could be paying mortgage rates between 2.5 and 3 per cent, which is a very low hurdle to clear as an investor. Still, there’s a case to be made for paying down a low-rate mortgage if you’re finding it hard to manage your mortgage as well as the cost of day-to-day living.
Paying down your mortgage for a period of time instead of investing won’t reduce your living costs right away. But at renewal time, you’ll have a smaller outstanding mortgage balance to carry forward and thus lower payments than you would have otherwise had.
Let’s say the balance on your mortgage will be $300,000 at renewal in 18 months and the rate you’ll get is 4.39 per cent, or one percentage point more than current discounted rates for a fixed five-year mortgage. Your monthly payments would be $1,874 in this case, assuming you intend to pay off your mortgage in no more than 20 years.
If you made a $10,000 lump-sum prepayment before renewal and got your balance down to $290,000, your monthly payments would be $1,811. You’ll have saved $63 per month, reduced the total amount of interest you pay over the entire mortgage and put yourself on a path to getting the mortgage repaid sooner.
Ideally, debt repayment and investing can be done at the same time. But with interest rates trending higher and investment returns hard to come by right now, it’s time to think about taking a temporary break from investing to attack your debt.
Toolkit For Deciding to Invest or Pay Down Debt
- Pay down debt or invest calculator
- Ernst & Young 2013 personal tax calculator
- Mortgage prepayment calculator
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