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rob carrick

A car loan is killing his cash flow – should he dip into his TFSA to pay the debt off faster?

A reader asked me this the other day and my answer is Yes. Preventing the financial damage that can be caused by an unaffordable car payment outweighs the negatives of using up some savings.

Last month, we looked at the question of whether it is better to pay down debt or invest for retirement. But this reader question about a car loan shows there is another debate we should have about debt – should you use your savings to pay down what you owe?

Before digging into this question, we have to acknowledge that emotions and psychology have as much to say as numbers. That was apparent in the reaction to the column on debt repayment versus retirement investing, which cited a report showing that investing for retirement is a clear win right now over paying down the mortgage because potential investment returns are so much higher than current mortgage rates.

There's a real sense of what we'll call debt regret settling into the households of the nation. Many people have borrowed heavily to buy homes and other things, and now they're finding it's a strain to repay what they owe. They want relief, and that's a big reason so many readers said they think that paying down debt is smarter than retirement investing (there's some distrust of the stock market and the investing industry, but we'll leave that alone for now).

Using some of your savings to pay down debt makes sense if it will help relieve severe financial stress, but let's set some rules. For one, leave registered retirement savings plans for retirement unless you face a five-alarm emergency like defaulting on your mortgage. Global News reported recently that the number of people making RRSP withdrawals is significantly higher than it was before the last recession. The numbers exclude RRSP withdrawals through the federal Home Buyers' Plan and Lifelong Learning Plan, which suggests the money is being used for debts and matters of financial survival.

Money sitting in a high interest savings account is most appropriate for debt repayment, be it in a tax-free savings account or a regular, non-registered bank account. These savings accounts pay 1 to 1.9 per cent at best and most debts carry higher rates.

The reader with the car loan has about $13,000 in what he refers to as his TFSA emergency fund. For two reasons, it makes sense to use this money to pay down the car loan, which carries a low rate of 2.2 per cent. One, the car loan is huge and, as he put it, killing his cash flow. Payments total $295 biweekly, which works out to $639 a month. While that seems high, it's not much above the national average level of car payments.

Two, this reader's emergency fund isn't tucked away safely in a high interest savings account. Instead, the money is invested in two specialty investment funds, which means they're narrowly focused products and not vehicles for getting broad, diversified exposure to stocks and bonds. One of the funds is doing well, the other not so much. They both may do great over the long term, but a surer outcome would be to pay off the car debt.

So how is it that debt repayment is better than investing for this reader, but just the opposite is true when comparing a mortgage paydown to retirement investing? Because a diversified retirement savings portfolio of stocks and bonds is reasonably expected to beat the cost of borrowing both today and in the future. With speculative investments, anything can happen.

Has a big car loan or other purchase given you a bad case of debt regret? If the debt is killing your cash flow, make paying it down your financial priority. Use some savings, or divert money you might otherwise have invested. Otherwise, understand that paying down debt is not automatically the best use of your money. Having some savings for emergencies is important, and so is investing consistently over the decades for retirement and other future goals.

What an odd place we're in right now with debt. Co-existing with the phenomenon of debt regret is the news that total household debt levels showed a 7.7-per-cent jump in the fourth-quarter of 2014 on a year-over-year basis. Apparently, Canadians only worry about debt after they take it on.

Globe app users click here for a chart showing how much debt you carry when financing a car purchase.

Desktop users click on image to enlarge