Paying Off Debt Wisely
When you're paying
off a loan, should you also be putting
money into savings or investments?
This is an age-old question with
one of those annoying answers: It
depends. Let's delve into
it!
You've probably heard that
simplistic solution: Always invest
if you can earn a higher interest
rate from investing than you are
paying on your loans.
Not necessarily! In fact, this can
be dangerous. Remember the stock
market frenzy? Unfortunately, a
lot of homeowners created more debt
for themselves by cash-out refinancing
or through home equity loans. When
the bear market hit, the reason
that this solution is not so simple
after all became far too clear.
Evaluating your debt
So how do you decide how to most
effectively use the money you earn?
The best answer lies in separating
good debt from bad debt. It's almost
always a good idea to get rid of
credit card and other high-interest
loans before you start setting aside
cash. However, you probably don't
want to accelerate mortgage or student
loans at the expense of saving for
retirement.
Feeling overwhelmed? Here’s
some steps you might consider following:
Make a list
List all of your debt and the interest
rates you are paying on each debt.
This will help you prioritize which
ones you should pay first. Don't
skip this step and just assume that
you automatically know where the
highest rates are - you might
be surprised! Then look at your
alternatives for saving and investing
and, if necessary, reset your priorities.
Pay off the high-interest debt
First, tackle any high-interest
credit card debt that you may have.
Based on the interest rates of most
credit cards, you'd have to
make a whopping 20% after-tax return
on stocks, bonds or mutual funds
to make them a better investment
than paying off a credit card with
an interest rate above 15% - so
you're better off paying off
the cards instead of investing.
Exception: If your employer offers
a retirement plan and will match
your contributions up to a certain
level, fund it up to that level
-- even if you have credit card
debt -- because you're getting a
100% return on your investment.
Drowning in debt? Consider liquidating
assets such as stocks and use your
savings (but not an RRSP!) to pay
off your credit cards.
Know which debt is good debt
Unless you have piles of extra cash
sitting around, it's usually
not worthwhile to pay off your mortgage
before paying off other debt. This
is because interest rates on mortgages
have been so low lately that chances
are your mortgage has the lowest
interest rate of any of your debt.
Exception: Close to retirement?
Try to pay off your mortgage and
any other debt before you retire
so that you can get by on less money.
Also, if you have student loans,
there's no rush here either,
since qualifying interest on student
loans can be written off no matter
how long it takes to pay them off.
Save and invest
Finally eliminated high-interest
debt? Now it's time to start
saving as much as you can. The best
place to begin is a company retirement
plan and/or RRSP.
Aside from a retirement account,
you'll need a contingency
fund. This is cash that is readily
available in an emergency so that
you don't have to rely on credit
cards. A good rule of thumb is to
have three months' living
expenses set aside (or six if you
have a less-than-steady income or
a job that has exposure to economic
fluctuations). Sock this money away
in a high-yield account, such as
a money market fund, each month
until you reach your desired amount.
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