You probably have some sort of debt. Most Canadians do; the average Canadian household has $1.78 in debt for every dollar of their annual salary. Credit cards, mortgages, vehicle financing—Canadian debts come in all shapes and sizes. So as a debt-carrying Canadian, what do you do when you have some extra money laying around? Invest, or pay down debt?
The decision boils down to compound interest
Compound interest is perhaps the most powerful force in finance. It’s why a small ‘drop’ in an investment fund can ripple out into a greater value over time. It’s what allows a nest egg to grow into a sizable retirement fund—or a debt to spiral out of control.
For an explanation of how compound interest works, let’s look at our Questwealth Portfolios:
We like to point out the difference in fees between our portfolios, which charge under 0.5% in fees, and the average mutual fund, which charges 2.24% in fees. While the difference may seem small, it can have a massive impact on performance: the more of your earnings that you keep, the more you can invest. These invested earnings produce more returns, which you can re-invest for even more returns. For example, if you have a $1,000 investment, the extra 2% or so in mutual fund fees would only cost you about $20 per year. However, that means that you’ve invested $20 less, so you’re missing out on the interest that $20 would earn. Over 10 years in a balanced portfolio with an expected return of around 6%, those fees compound into a difference of about $300 ($200 in fees, $100 in lost interest). After 30 years at 6% returns, it balloons out to a whopping $2,400 ($600 in fees, $1,800 in lost interest).
The compound interest of debt works in much the same way, only instead of building money, you’re building debt. The more debt you have, the more interest you’re charged, which grows your debt, which grows your interest charges, and on and on.
“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it” – Albert Einstein
If you would like to learn more about how compound interest works, see our article on the magic of compounding.
The simple way to an informed decision
The fact that compound interest works similar in both investment and debt makes it very easy to compare the two options on a basic level. One will compound up when you invest, the other will compound down until it’s paid off. Whatever moves your balance the most is going to have the biggest long-term impact.
For example: Say you have an extra $1,000 laying around, a balanced Questwealth portfolio with a 6% expected return, and an old student loan with a 5% interest rate. Let’s see what happens if you invest in each:
Interest per year
In this case, investing $1,000 in your Questwealth Portfolio will earn you $60 per year. Investing in your debt will save you $50 in interest. So, at the 6% return rate, investing will net you $10 more.
Now let’s say you have the above cash, portfolio, and student debt, but you also have an outstanding credit card debt with an 18% interest rate:
Credit card debt
Interest per year
In this case, the credit card interest is 300% higher than your expected returns. In this situation, paying down the credit card would absolutely be the correct choice, with investing as your next choice once the credit card is paid down.
Special considerations to make when contemplating your options
While the ‘simple way’ is a great rule-of-thumb, things aren’t always that easy. Some loans have strict repayment schedules that impose penalties for early repayment. Some debts, such as some vehicle financing, don’t incur interest at all. Others incur interest, but only after a certain event, like federal and provincial student loans that don’t accumulate interest until after graduation.
The type of investment account can also change the relative value of your investment. If you’re contributing to an investment in a taxable account, then you might want to consider capital gains taxes on your returns. You will need to know if you have enough contribution room for the investment if you’re contributing to a tax-free or tax-deferred account such as a TFSA or RRSP. RRSP contributions also have other factors to consider: They’re tax deductible, which grants them additional value—but they also have restrictions when it comes to accessing that money before you retire, meaning you can’t get it back without incurring significant penalties. So if you’re going to need to access the money at some point, or if you’d like to have it available for an emergency, an RRSP isn’t your best choice.
Invest in your long-term greater-good
We get it. Investing in the market is much more exciting than debt management. But a healthy portfolio needs money to contribute. A high-interest debt can cost you in the long run, seriously clamping down your long-term investing potential.
In other words, when you have a bit of extra cash to contribute, paying down high-interest debt just might be your best long-term investment.